00:00Credit markets should be pricing in more pain from AI disruption.
00:04I feel like there's a lot of pain. At least I spend the bulk of my time looking at equity
00:08markets.
00:08What's going on in your neck of the woods?
00:12Yeah, I mean, credit has definitely started to price in certainly AI disruption.
00:16I mean, our view is that there's a legitimate belief that we have that AI disruption is coming faster
00:23and it's impacting more than software.
00:25And we've really been of that view for the last few weeks.
00:27In terms of the market pricing, you've definitely seen dispersion.
00:32So different markets are behaving in different ways.
00:34Loan markets, we think, are more greatly impacted by disruption.
00:38You're seeing the leveraged loan space down about a point, let's say, in terms of the overall market
00:45or wider in spread by about 30 to 40 basis points.
00:49High grade and high yield spreads are flat in the case of investment grade,
00:54about 10 basis points wider in high yield.
00:55So all the price action, I would say, for the most part is really in tech and in leveraged loans.
01:01And so in terms of the reason for the call, we think this repricing has further to run.
01:06And the simplest way to look at it is really to focus on the fulcrum, which is the tech sector,
01:11and in particular, leveraged loans.
01:13So our essentially analysis suggests that you've had an increase of about 5% of loans trading stressed over the
01:21last two weeks.
01:22And so effectively what we think is the market's discounting an increase in the tech sector of about 1%
01:27to 2% more defaults over the next 12 months.
01:30Our TAIL scenario, which is a rapid and aggressive AI disruption scenario, suggests defaults could go up to 10%.
01:38And for context, the high yield shale crisis had energy defaults at 20%.
01:43So we don't think that's overly aggressive.
01:45We ultimately think the market should be essentially repricing to about 3% to 5%.
01:49And so our characterization is essentially that we think we're in the earlier to middle innings of the repricing and
01:56credit.
01:56Right. Right. It's interesting.
01:58I mean, looking at your note, you make the point that for high-grade and junk bonds, the direct risk
02:03from AI is less severe.
02:05And certainly, I mean, if you take a look at spreads, you don't necessarily see any sort of repricing going
02:10on.
02:10Spreads are still super tight.
02:12But leveraged loans, talk to us about that sector a little bit more.
02:16What parallels we can draw there to maybe extrapolate what's ahead?
02:22Yeah, I think it broadly is loans.
02:25So certainly leveraged loans, the $1.5 trillion leveraged loan market, but even more so the private credit market, which
02:30is $2 trillion.
02:32You know, we did a rapid and aggressive scenario analysis.
02:36And again, we're taking part of, but I would say to be candid, about 30% to 40% of
02:41it into our baseline view.
02:42But at the tail scenario, we think ultimately if this occurs over, let's say, a period of 12 months and
02:49it's very aggressive,
02:50we think the disruption potential in a tail risk scenario essentially could drive leveraged loan defaults up about 5%
02:58and private credit defaults up about 8% from current levels.
03:02And so if you put that in nominal terms, I mean, both of those markets are $3.5 trillion.
03:08You know, in the tail scenario, a default rate increase of 5% to 8% essentially could drive an
03:14extra $200 or $250 billion in defaults.
03:17And so it is material.
03:20Right now, we think, again, the market is going to continue to price this more in a wave, to use
03:25an ocean analogy,
03:26as opposed to a spike in default risk.
03:27But we do think the market is behind this and needs to catch up.
03:32And we'll continue, we think, to see that into the next week or two.
03:36And talking about that tail outcome, though, how likely, in your view, does that play out?
03:40And how long does it take to play out?
03:41And what are the ultimate knock-on effects if it were to take place in the coming weeks or months?
03:48Yeah, it's a great question.
03:49I mean, I think there's opposing forces pushing both ways.
03:53I mean, on the one hand, you've got certain businesses take software and SaaS companies
03:57where their contracts tend to be longer term, tend to be annual.
04:01And so some of our investors feel insulated by the view that, you know,
04:05essentially revenue and cash flow will still be somewhat predictable.
04:10The flip side to that is really that market forces, as we've seen, can drive funding costs higher
04:16and can effectively tighten the cost of capital, or for the lowest quality firms,
04:20essentially stop them from the ability to tap or access capital markets and essentially to refinance.
04:27So there's a number of moving parts here that I think are working in different directions.
04:32Ultimately, if this happens faster, that's where you get into the scenario of more front-loaded losses,
04:38and those losses could be quite severe.
04:41Keep in mind that analysis that we did didn't essentially look at spillover effects.
04:47So it wasn't kind of a complete tail scenario, but very much just one focused on the default risk
04:53that could manifest itself really from AI disruption.
04:56So I don't want to go too far down the road, so to speak, but I think the bottom line
05:00is
05:00if you did get a default environment in the loan market where default surged to our tail risk case,
05:06which is up 5% to 8%, you could certainly expect spreads to be several hundred base points wider.
05:12Right.
05:13And you will find that the lowest-rated part of the market, let's say below mid-single B,
05:17certainly below double B, potentially would lose market access.
05:21And so the refinancing concern that we also talked about in the note was about 20% of tech as
05:26a sector,
05:27both in leveraged loans and private credit, all have refinancing that needs to be done in 2028.
05:33Again, about 20% of all debt coming due essentially in about two years.
05:38Right.
05:38Well, I want to talk about this supply dynamic a little bit more,
05:42especially in the context of what we're seeing in high grade.
05:45Because as you mentioned, when it comes to disruption risks,
05:48maybe the risk there isn't as severe as it is with loans.
05:51But you think about just all this supply coming through.
05:55I saw a recent estimate from Guggenheim saying that we could be looking at $120 billion this year alone
06:01in net new supply.
06:02What might that mean for spreads as the market tries to absorb that?
06:09Yeah, we've actually got a little bit of a different view than the consensus there.
06:13So I think for the investment-grade market, we do think that the companies will be less impacted.
06:17Part of that is they have stronger balance sheets to attack competition from AI disruption head-on.
06:23The other part of that, candidly, is the rating agencies have had a model over the last decade and a
06:28half
06:28that investment-grade ratings should be more stable.
06:31They should look through the cycle.
06:32And so I don't think the downgrade, obviously in high yield it's default,
06:36but investment-grade it's really downgrade risk, is that imminent, if you will.
06:41I think away from that, supply certainly we think will weigh on the investment-grade market.
06:46We're underweight or essentially cautious on the tech sector.
06:50But I'm not convinced that that's going to drive a significant widening in high-grade spreads.
06:55I think the bigger issue is if you think about the amount of capital spending, as we've written,
07:00that needs to get done, it is realistic that you need to see the hyperscalers tap all markets.
07:05So we saw them earlier in the month obviously tap the sterling and the Swissy market.
07:11And we ultimately think they also need to tap private markets, for example,
07:15some of the data center-specific financing that you had last year.
07:18And so that's really where I think the risk is first, is if you're worried about too much supply,
07:24potentially widening spreads or tightening risk appetite if there's just too much and you get indigestion,
07:31clients can't absorb all that paper.
07:32I'm a lot less worried about an unsecured deal from a hyperscaler like Google
07:37than I am essentially some of the data center or the other proxy financing that's done in private markets.
07:44That's where I think if there is a bottleneck or a constraint,
07:48that's where I think it would show up later this year first.
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