Why ChatGPT might be affecting your bond fund

What does ChatGPT have to do with bond yields?

At first glance, not much. One is an AI chatbot. The other is the return investors earn for lending money to governments and companies.

Yet the artificial intelligence (AI) boom may be helping to push bond yields higher. For fixed-income investors, that is worth paying attention to.

The usual suspects

When bond yields rise, and prices fall, investors tend to look for familiar explanations.

Perhaps inflation is proving more persistent than expected. Maybe central banks are keeping interest rates higher for longer. Or perhaps stronger economic growth is prompting investors to demand greater returns from bonds.

All these factors matter.

But another story is unfolding in the background. It has less to do with the economic cycle and more to do with a fundamental feature of markets: supply and demand.

Too many borrowers, not enough lenders?

Governments and companies both need capital. Investors provide it in exchange for future interest payments and the eventual repayment of principal.

As more borrowers come to market, investors can become more selective. In many cases, they will demand higher yields before committing their capital.

For years, concerns about bond supply focused mainly on governments.

Large budget deficits, ageing populations, rising healthcare costs and growing defence spending have increased borrowing requirements across much of the developed world. Governments have been issuing more debt, requiring investors to absorb that additional supply.

That story is well understood. What is perhaps less widely appreciated is that governments are no longer the only heavy borrowers in town.

Enter the AI boom

Building AI infrastructure requires significant capital.

Data centres are expensive. So are advanced semiconductors, power networks and the digital infrastructure needed to support increasingly sophisticated AI models.

Many of the technology companies leading this investment wave have historically relied heavily on cash generated by their businesses. Increasingly, however, they are also turning to bond markets for funding.

That matters because some of this borrowing is taking place on a scale large enough to influence the wider market.

In effect, governments now face greater competition when seeking investors’ capital.

The important question is what happens when governments and some of the world’s largest companies simultaneously issue substantial amounts of debt.

Why this matters for bond investors

Supply is only half the equation.

At the same time that more bonds are being issued, some traditional sources of demand have become less supportive.

Central banks are no longer purchasing bonds on the scale seen during the quantitative-easing era. Some sources of demand for long-dated bonds, including pension funds, have also become less reliable. Investors are also questioning whether bonds provide the same diversification benefits they once did.

Put those trends together and the implications become clearer.

More bonds are being issued, while some traditional sources of demand have weakened. If additional supply outpaces investor demand, yields may need to rise to attract sufficient capital.

Put differently, bonds may have to work harder to earn their place in investors’ portfolios.

Good yields or bad yields?

Not all increases in bond yields should be viewed negatively.

If yields are rising because investment is increasing, productivity is improving and economic growth prospects are strengthening, that can represent a healthy development.

After all, capital raised today could help finance technologies that support tomorrow’s economic growth.

But if yields are rising because investors are increasingly concerned about inflation, government finances or the long-term sustainability of public debt, the picture is less encouraging.

The challenge is that both forces may be operating simultaneously. That is one reason bond markets warrant particularly close attention.

Where are the opportunities?

For much of the period following the global financial crisis, investors became accustomed to low inflation, ultra-low interest rates and strong structural demand for government bonds.

Today’s environment looks different. Governments continue to borrow heavily, AI-related investment increasingly requires capital, and investors are becoming more selective about where they allocate it.

But higher yields can also create opportunities. For example, shorter-dated corporate bonds may offer attractive coupon income while typically being less sensitive to changes in interest rates than longer-dated debt.

Investors should resist simply selecting bonds offering the highest yields. Those yields can be compensation for greater default risk.

More compelling opportunities may instead lie among financially sound issuers whose bonds offer sufficient income to compensate investors for the risks they are taking. This makes careful credit selection particularly important.

Final thoughts

ChatGPT is not setting bond yields. But the investment boom unleashed by AI may be changing the balance between supply and demand in global bond markets.

For investors, that additional competition for capital may also create opportunities to earn attractive income from carefully selected bonds.

Looking ahead, bond investors may need to pay almost as much attention to Silicon Valley as they do to central bankers.