AI Bond Flood Pressures Credit as $400B Hyperscaler Issuance Looms

Hyperscalers may issue $400 billion in investment-grade bonds in 2027, on top of $250 billion this year, pressuring credit spreads wider as supply floods the market.

"You have to compare how much you get paid for what risk," said Dominique Toublan, head of U.S. credit strategy at Barclays. "The risk you have to interest rates is much, much higher on the hyperscaler long-end side."

Barclays tracking shows spreads on a group of investment-grade hyperscaler bonds — including Alphabet, Amazon, Meta, Microsoft, Oracle and SpaceX — widened by almost a quarter percentage point over the month through July 30. Alphabet bonds maturing in 2075 and Amazon bonds maturing in 2065 both yield around 6.5 percent, while Meta bonds maturing in 2065 yield over 7 percent, according to FactSet.

The Fed's decision last week to hold rates without forward guidance sent longer-term Treasury yields soaring, increasing duration risk on the longest corporate bonds. Investors may find better relative value in data-center project bonds, which offer yield pickups of roughly half a percentage point to close to two points over their underlying hyperscaler tenants' bonds, according to Morgan Stanley.

The Long-End Trap

Longer-term bonds carry hidden risks beyond a company's financial health decades from now. The ICE BofA index of U.S. high-grade corporate bonds with a weighted average life of over 20 years pays about a 1 percentage point spread over Treasurys, according to FactSet. That cushion was twice as wide as recently as 2022.

High yields on Treasurys could also damp demand for corporate bonds that offer only a modest bump over government benchmarks. Going for shorter-term, top-rated hyperscaler bonds reduces interest-rate risk but often means an even smaller additional yield over Treasurys.

Data-Center Bonds as the Sweet Spot

A part of the market where investors get additional yield spread is in bonds sold by companies constructing data centers for hyperscalers. These include bonds issued by joint ventures or firms backed by big real-estate investors such as Blackstone and Related Cos., with future tenants including Microsoft, Alphabet and Meta.

Having hyperscalers with top-notch credit ratings as future tenants with strong ability to pay should be a benefit. As construction risk recedes, these bonds could "look increasingly like secured, lease-backed extensions of hyperscaler credit rather than purely bespoke project financings," Barclays credit analysts wrote in a recent note.

Investors can get pickups of roughly half a percentage point to close to two points of additional yield in investment-grade data-center bonds over the bonds of their underlying hyperscaler tenants, according to Morgan Stanley strategists' tracking.

Among the risks: a facility doesn't get built on time or overruns its expected cost. Power can be difficult to secure, and political opposition is growing in some jurisdictions. The terms of the relationship with a tenant need careful scrutiny, and there is the future risk that the tenant doesn't renew a lease.

"With many data-center bonds, your primary risk is whether they get built or not. It's a defined risk, with an endpoint: Once the asset is stabilized, it starts to generate cash flow," Vishwas Patkar, Morgan Stanley's head of U.S. credit strategy, said in an email. "That's different from the broader, more open-ended risk that the whole AI model doesn't work out as expected."

Project bonds may also see relative price jumps as construction moves along, or potentially upgrades. Hyperscalers already rated toward the top of the credit spectrum might not be as likely to be upgraded. Microsoft is already rated triple-A, the highest rating — higher than the U.S. government.

The far-out future of AI remains hazy, and it is increasingly intertwined with huge questions about interest rates and inflation. Investors might be better paid to take the risk that at least the stuff gets built.

This article is for informational purposes only and does not constitute investment advice.