AI-Driven Bond Issuance Boom May Disrupt the Landscape of Passive Credit Funds

The largest wave of corporate bond supply in history is about to collide with the rapid growth of passive buyers. Some investors warn that turbulence may ensue.

As tech giants scramble to raise unprecedented funds to develop artificial intelligence, passive funds are set to take on an increasing share of these deals. These strategies — tracking indices or buying baskets of bonds until maturity — have surged in scale in recent years, sparking concerns that their indiscriminate bond-buying distorts risk metrics and exposes investors to risks.

Now, the record-breaking volume of bond issuance will test these buyers on multiple fronts. Some fund managers believe the supply surge could pose a risk of sharp market adjustment, especially as risk premiums are already near their lowest levels since the financial crisis. Others point to another risk: the investment-grade bond market itself is undergoing a structural shift.

“Passive investors are forced to take on a larger share until everything completely collapses,” said Bryn Jones, Head of Fixed Income at Rathbones Asset Management. Jones expects the surge in tech company bond issuance to repeat the telecom issuance boom at the turn of the millennium, which ultimately led to a widening of risk premiums in that sector.

Guggenheim Investments has also warned that the massive scale of new bonds could be difficult for the market to absorb. In a report this week, the team led by Chief Investment Officer Anne Walsh noted, “As the market digests the new supply, spreads may face modest upward pressure.” They expect that mega-cap companies alone could add as much as $120 billion in net corporate bond supply this year.

Another consideration is how additional bond issuance by highly rated companies such as Alphabet, Meta, and Microsoft will alter the overall composition of credit indices. Concentration risk has already sparked concerns among some equity investors, who worry that if the AI trade falters, the entire market could be affected.

Currently, tech stocks account for less than 10% of the Bloomberg US high-grade index, but as the sector’s share of total issuance rises, this proportion will increase significantly. A similar trend has emerged in the UK market. Historically, tech stocks have never made up a large share of the sterling index, but with Alphabet’s issuance this week, the company will become the third largest issuer in the Bloomberg Sterling Investment Grade Index when tracker indices rebalance weights at the end of this month.

“Just a rate product”

These composition changes are significant for spreads, as high-quality issuers such as those in the tech sector tend to have lower risk premiums. As the proportion of such bonds rises, the market’s focus on spreads diminishes, and the underlying government borrowing rate — another component of corporate bond yields — becomes the main performance driver.

Steffen Ullmann, Senior Portfolio Manager for Investment Grade Bonds at HAGIM GmbH, pointed out, “Investors think they are buying passive corporate bond vehicles expecting correlation with other asset classes, only to discover they are holding a pure interest rate product.”

This poses a potential risk for passive investors, especially in the case of fixed-maturity funds favored by retail investors. Such investors may miss out on the higher returns typically offered by corporate bonds, while being unprepared for the macroeconomic and geopolitical risks that come with government debt.

Admittedly, the specific impact on passive investment performance is almost impossible to quantify at present, as the eventual supply levels and the ultimate impact of AI on tech companies remain unknown.

Editor: Li Tong