The speed of AI-driven change is giving rise to a new form of structural credit risk - underpinned by an inability of legacy companies to amortise (gradually write off) debt, which potentially heightens the risk of permanent capital loss, rather than temporary earnings weakness.
At least that’s the take of Richard Quin, chief investment officer at Bentham Asset Management, who expects AI-disruption to bring with it brutal outcomes for bondholders.
Quin argues that while financial markets look stable right now – with fixed income markets currently enjoying the calm of tight spreads and stable headline employment – the widening gap between future AI winners and losers threatens to undermine this.
What investors need to understand, adds Quin, is that while big companies are using AI to boost profits, their smaller counterparts are struggling with higher costs and weaker productivity.
While AI is arguably creating efficiency and boosting productivity, Bentham believes it also represents a new type of risk for people who lend money to companies, aka bond investors.
‘Schumpeterian’ credit gap
The net effect of what Quin has dubbed the ‘Schumpeterian’ credit gap – where innovation destroys old businesses faster than they can adjust – is that bond investors could lose money permanently, not just temporarily.
“Drawing on economist Joseph Schumpeter’s idea of ‘creative destruction,’ innovation may create long-term economic value, but it can be brutal for bondholders. For a credit investor, it can be an engine of defaults,” he said.
Nowhere is the unattractiveness of older companies more evident than in the 28,000 to 31,000 lower-growth, legacy firms that PE companies have been struggling to offload for some time.
While this raises questions over the PE industry’s ability to buy and flip companies for a profit, the more vexing question is what happens to firms that can’t be sold.
What’s equally worrying are some projections that the era of the ‘PE zombie’ – which traps investor capital while managers often continue to collect fees - could be just around the corner.
AI bubble
Echoing similar concerns, consulting firm Oliver Wyman has warned financial institutions that the rising risk of an AI bubble could see more than US$30 trillion (A$42.19 trillion) wiped off market value.
At current market levels, it is estimated that a crash comparable to the early 2000s would wipe out approximately US$33 trillion of value – more than the entire U.S. economy.
To help investors make sense of the potential winners and losers across consumers, corporates and labour markets, Quin points to the “K-shaped economy” – propped up by a more affluent cohort - an economic backdrop against which corporates' fortunes are being won and lost.
“We have a problem of haves and have nots in the consumer and the corporates,” Quin notes.
“The upper part of the K is doing very well.”
What’s hard to ignore, adds Quin, is the growing concentration of spending power, with the top 10% of income earners now controlling close to half of consumer expenditure – a marked shift from the 1990s.
Rewriting the corporate narrative
Quin also reminds investors that AI is rewriting the corporate narrative in real time, with large, capital-rich companies yoking AI to expand margins, while smaller and mid-cap firms are becoming trapped by higher servicing costs and weaker productivity.
“AI productivity comes with labour displacement. While markets have celebrated AI’s productivity upside, the more pressing risk lies in what is being destroyed in the process. AI gives us productivity, but it eats employees or consumers,” he said.
“The risk will be in the next two to three years and could be quite dramatic,” Quin says.
Meanwhile, global institutions, including the IMF and the World Economic Forum, are warning of the greatest labour reshuffle in a century, with disruption increasingly hitting higher-paid professional roles rather than just manual work.
In light of these projections, Quin urges investors to look beyond aggregate employment figures, which can mask deeper workforce churn.
“Stepping stone roles are disappearing,” Quin also noted.
“AI may be removing the ladder on the career board for young graduates.”
Future relevance
In this environment, credit analysis is no longer only about cash flow coverage but about future relevance.
AI aside, Quin also warned about current credit valuations, highlighting concerns over tight spreads and underpriced leverage.
He observed that the investment-grade universe has weakened structurally, now featuring a significantly higher proportion of BBB-rated issuers compared with previous cycles.
“Credit risk isn’t just about the ability to pay,” Quin says. “It’s about the ability to still matter in the future.”
Beyond AI, Quin is cautious on credit valuations, particularly given tight spreads and underpriced leverage.
With the investment-grade universe having weakened structurally, investors are now witnessing a higher proportion of BBB-rated issuers compared with previous cycles.
“The downgrade risk on BBBs is still there,” Quin said, “especially if AI disruption makes this a far less ‘normal’ cycle than markets are pricing.”
Slowdown
Meanwhile, in Australia, where the market is now pricing in at least two rate hikes this year, Quin expects to see a corresponding slowdown in the Australian economy.
While most of the return is in the interest rate right now, Quin also believes that the Australian dollar (A$) is an alternative for investors holding a high-quality government bond that doesn’t have a deficit out of control and is a potential reserve currency.
“I see problems with it too, because it’s a cyclical currency and a commodity-based currency. But, again, there are changes that we’re seeing here that are unusual,” he said.
In response to prevailing market dynamics, Quin has positioned its multi-sector portfolios, including the Global Income Fund, defensively.
He has decreased the fund’s credit risk, gone up the credit curve and increased exposure to government bonds and higher-quality securities, believing most of the return opportunity is now in rates rather than spreads.
The firm has also rotated back into Australian duration following the sell-off in domestic rates and thinks the fixed-interest yield right now offers good protection for investors.
“We think corporate credit is reasonably expensive right now. Floating rate and capital securities still offer value,” he said.
“While cautious on traditional credit beta, we continue to favour loans for their carry, even as spreads compress, and sees value in capital securities relative to local hybrids. We think it’s much better value than the local hybrid markets.”
