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Credit default swaps have made a steady comeback in recent years, as Alphaville periodically noted with pleasure. But it took the AI frenzy to really revive the market.
CDS on many big tech companies didn’t even exist a few years ago, but really took off this summer, as MainFT’s Ramsay Hodgson and Euan Healy wrote a few weeks ago:
Investors are rushing to buy credit default swaps to protect their portfolios in case the AI boom collapses, sending trading volumes soaring for an instrument that rose to prominence during the global financial crisis.
The surge in borrowing to finance billions of dollars in AI infrastructure spending is fueling demand for these insurance-like derivatives, which pay off if the company they’re tied to defaults on its debt.
As the MainFT article notes, the simplest way to think of CDS is as an insurance contract that protects the buyer against the borrower reneging on their debts. But they can be continually bought and sold, and you don’t need to be a creditor to do so.
This makes some people disgusted – like if you could take out insurance on a neighbor’s house to bet it would burn down – but it means investors can easily take long and short positions in a company’s or country’s debts, which should, all else equal, reduce borrowing costs. Additionally, CDS work as a clear, real-time indicator of a borrower’s creditworthiness and can tell us all kinds of interesting things that their stocks or bonds sometimes can’t tell us.
The typical CDS contract has an insurance term of five years. The premium you pay is expressed in basis points, and to get a simple annual cost, simply multiply it by the insured amount. For example, Nvidia’s CDS is currently priced at 141.5 basis points, so it costs $141,500 per year to insure $10 million of debt against default. We will not discuss variation margins, credit event settlements and auctions, etc. in this article, because life is too short.
But here are some charts showing how CDS prices of some of the hottest AI and AI-adjacent have moved over the past year (by the way, the ticker for Alphabet CDS is GOOF is 👌).
Here are the prices of CDS from Broadcom, Oracle and SpaceX, which have climbed again.
. . . while CoreWeave is in a category of its own.
There are three distinct, although related, metrics to keep in mind when discussing CDS.
First there is the cost of the CDS, as shown in the charts above. Then there is the volume of CDS contracts linked to a specific company, or the open interest. Then there is the trade volume for these CDS, the value of the contracts that change hands. This may seem silly to point out, but Alphaville often sees people confusing the last two in particular.
And as Barclays analysts noted in a report last week, the AI CDS story goes well beyond just rising prices. Even excluding CoreWeave, the net notional value of AI-related CDS contracts has now climbed to almost $30 billion, up from less than $7 billion a year ago.
The top 10 hyperscaler and semiconductor companies tracked by Barclays now account for nearly 14 percent of the entire U.S. single-sign CDS market, up from 4 percent at the same time last year, while their share of single-sign CDS trading volumes has quadrupled over the same period to around 20 percent.
And while CoreWeave is in a class of its own when it comes to CDS pricing, Oracle is king of the hill in terms of the size and dynamism of its CDS market.
Larry Ellison’s company is now the largest and most active sector of the US CDS market, with a four-week average weekly trading volume of $2.3 billion – more than double that of Broadcom, Nvidia or Alphabet – and open interest of almost $7 billion. Given that the company is still rated in investment grade territory, this is quite remarkable.
Importantly, none of these CDS prices indicate serious near-term concerns about solvency (with the obvious exception of CoreWeave). But the widespread increase in open positions, trading volumes and prices indicates that investors are starting to feel a little nervous.
There are other interesting elements in the Barclays report, such as the fact that CDSs incorporate more investor nervousness than the bonds these companies have issued, thus opening up a positive “base” between the two that some investors might try to exploit. The base is particularly high at Oracle, Broadcom and AMD.
But the main takeaway from Alphaville is that the CDS market is now officially back up and running. 🎉
Gn bussni
