Hyperscaler Debt Flood Brings Derivatives Bonanza

(Bloomberg) — As big tech companies raise hundreds of billions of dollars to fund artificial intelligence investments, Wall Street banks are increasingly finding they have to trade more credit derivatives to keep doing business with the hyperscalers.

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The surge in activity is creating an opportunity for hedge funds to profit from banks’ growing demand for these instruments.

Banks typically face limits on how much exposure they can have to a single company across loan portfolios and derivatives books. But so-called hyperscalers such as Meta Platforms Inc. and Alphabet Inc. are raising so much capital to fund their artificial-intelligence programs — they are estimated already to have borrowed more than $250 billion globally for AI — that banks may be starting to approach those limits.

That’s where credit derivatives come in: they let banks buy protection against a company defaulting on debt, reducing their exposure to a borrower. They can then lend the firm more, underwrite its debt and trade derivatives with it.

Banks are constantly buying and selling credit derivatives tied to hyperscalers as their exposure shifts. But they are generally purchasing protection, because the derivatives give them the capacity to win more lucrative fee business. Their demand has driven up the cost of protection on hyperscalers to unusually high levels relative to their credit ratings. And hedge funds are looking to profit by selling that protection that can look overpriced.

“It’s the best opportunity in AA credit default swaps in a very long time,” said Andrew Weinberg, portfolio manager at Saba Capital Management, referring to the opportunity to sell protection on highly rated hyperscalers at prices typically seen for smaller, lower rated companies. “You are dealing with an inefficient market.”

Take Meta credit default swaps. Five-year contracts traded on Friday at about 0.73 percentage point annually, meaning a hedge fund selling protection on $10 million of principal can collect $73,000. There’s relatively little risk: Meta is graded AA- by S&P Global Ratings and Aa3 by Moody’s Ratings, the fourth-highest level.

It’s far more lucrative than selling CDS tied to companies in the broader North American investment-grade index. Five-year default protection on $10 million of the index cost about $52,000 annually, and the index’s average rating is about BBB+, or four notches lower than Meta. Selling Meta CDS therefore can generate significantly higher returns with higher rated credit.

Read: AI Bubble Fears Are Creating New Derivatives: Credit Weekly

Wall Street dealers that facilitate such trades say much of the demand for hyperscaler CDS is coming from banks’ credit valuation adjustment — or CVA — desks, which manage hedging arrangements.

Bank of America Corp. is among the dealers seeing a surge in activity. Monthly notional volumes of hyperscaler CDS trading at the bank are up tenfold since the beginning of 2025, according to Matt Mandell, BofA’s head of US single-name CDS.

“Investors continue to look to buy hyperscaler CDS, and a lot of that does come from the CVA desks,” Mandell said in an interview. “They’re trying to avoid being constrained by credit limits.”

Bank demand is driving up prices for hyperscaler CDS, and pushing trading volumes to record highs.

CDS tied to Microsoft Corp., Amazon.com Inc. and Oracle Corp. notched $4.6 billion in notional trading volume in the first quarter, from $759 million a year earlier, according to Depository Trust & Clearing Corp. Meta CDS — only launched last October — had $534 million in notional trades, more than double the prior quarter. The figures likely understate activity because DTCC caps individual reported trades at $5 million.

Read: $300 Billion AI Debt Binge Spreads From Wall Street to Tokyo

With the artificial intelligence buildout projected to cost $5 trillion through 2030, CDS-selling hedge funds may have plenty more scope to profit.

For one, the debt spree is going global, with hyperscalers increasingly borrowing in currencies including euro, sterling and yen. That often forces CVA desks to buy more CDS, as companies often hedge foreign-currency exposure back to dollars through cross-currency swaps with banks. CDS can also help CVA desks hedge indirect exposure to data center deals and loans backed by graphics processing units.

“Banks are buying CDS to open up their credit lines, allowing them to trade and lend even more with hyperscalers,” Bofa’s Mandell said.

Demand is coming from other places too. Mandell is seeing more equity investors buy hyperscaler CDS as a cost-effective way to hedge stock positions. Asset managers and private credit funds are trading CDS on the companies as well.

Meanwhile, S&P Dow Jones Indices has added Meta, Alphabet and Microsoft to its CDX Investment-Grade Index, and JPMorgan Chase & Co. recently introduced a CDS basket that traders can use to bet against five hyperscalers’ debt.

Morgan Stanley strategists Vishwas Patkar and Joyce Jiang say there’s good risk-reward in buying protection on hyperscalers versus the broader investment-grade CDX index. While accepting that big tech firms are exceptionally high-quality, they say surging debt supply is concentrating exposure across a small set of issuers.

“Quality deterioration remains a risk,” they wrote in a note. “We like funding these shorts by selling protection on the broader index, which has less exposure to technology names.”

Listen to a podcast with Principal Asset Management about blue-chip firms risking their credit scores by piling on debt.

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