In recent years, no shortage of column inches has been devoted to the dangers posed to passive equity investment by the exponential rise in share prices of the world’s biggest technology companies.
And for good reason. US equity market concentration is at historic extremes, with the top 10 stocks accounting for roughly 39% of the S&P 500 index. Driven by the artificial intelligence (AI) boom, this has heightened concerns over the risks investors are being exposed to, and the difficulty in building a diversified portfolio.
The fact that the very same companies are now being forced to turn to debt markets to help fund this colossal investment in AI infrastructure is starting to have implications for bond investors too. Once more, this applies especially to those who rely on passive investment vehicles.
Unlike equity indices, where individual stocks are weighted according to their market capitalisation, and ultimately their profitability, bond indices are dominated by the most indebted companies.
While these US tech giants may be enormously profitable, building out global data centre and AI infrastructure and related power supplies is proving hugely costly.
The big five ‘hypescalers’ – Google’s parent Alphabet, Amazon, Facebook owner Meta, Microsoft and Oracle – have indicated planned capital expenditure of around $800 bn this year. That would represent a more than fivefold increase in the space of just three years.
And financial analysts are forecasting capital expenditure outlays by the same five firms will climb further, to around $4trn, over the subsequent four years. Even that sum may be insufficient given the rate at which the price of semiconductors and other components, as well as the cost of constructing data centres, has been rising.
Little wonder then that these companies have been turning to corporate bond markets with increasing frequency. JP Morgan reckons these five firms alone, some of which had been virtually debt free until relatively recently, will need to issue an extra $1.5trn worth of bonds over the next five years.
The technology sector currently accounts for just over $1trn of outstanding debt. That represents 14% of the US investment-grade bond market, up from just 7% a decade ago. An additional $1.5trn of debt would push that figure significantly higher still.
Big Tech may not make its money back, but it will survive
Investors in passive bond funds, tracking traditional bond indices, should be aware of the increased risks debt issuance on this scale potentially exposes them to. For the more sceptical among them, recent history provides a cautionary tale.
The US shale boom of the previous decade was largely debt funded. The yield differential over government bonds stayed tight long past rational justification because the sector’s weight within the index kept growing as passive funds soaked up fresh supply. When the cycle turned, losses were severe and concentrated.
The parallels with today are uncomfortable: enormous cap-ex programmes with highly uncertain returns, funded at low interest rates, being readily absorbed by the market. The difference today is scale: the amount of debt being issued dwarfs that sold by energy companies.
This is not to say all these technology companies’ bonds are unattractive. While there may be good grounds for questioning whether this investment will deliver satisfactory returns, it is important to remember much of it is being funded out of cash flows.
Big Tech may not make its money back, but it will survive. That puts the more established firms in a very different position to companies in previous market frenzies, where huge investment was financed by new debt or equity and the bursting of the bubble wiped them out.
And there is an argument that at least in some cases these tech giants represent a better credit risk than many governments.
But SpaceX’s troubled inaugural bond issue is a cautionary reminder of the risks posed by the current scale of bond issuance. The worry is that passive bond funds, with no embedded caps on issuer weightings, are creating a reflexive loop: issuance growth is mechanically increasing index weight, which compels further passive buying. With price discovery taking a back seat, the market’s ability to curb further issuance via higher yields is compromised.
And it is not just bond investors who should be on the alert. Surging debt issuance by these firms is exposing those multi-asset investors who are making use solely of passive building blocks, to far more risk than they might be appreciating. After all, it is the very same companies whose shares have begun to dominate US and global equity indices.
In the current environment, with equities soaring and corporate bond spreads at historically low levels, it might seem alarmist to warn of the rising risks facing investors. But with no end in sight to the AI splurge, the case for capping the weight of individual issuers, or actively managing bond exposures, is stronger than ever.
Mark Versey is chief executive officer of Aviva Investors
