AI and the Bond Market: An Analysis of the Opportunities and Risks

Fast expansion of AI infrastructure has sparked one of the largest investment cycles in recent history. In this discussion, members of our corporate, securitized and municipal fixed income teams evaluate the opportunities and risks across asset classes.

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  Warren Pierson:

  Hi, Warren Pierson here, the Co-Chief Investment Officer at Baird Advisors.

  And with me today, I’ve got Meg Dean, co-lead on the securitized sector, Andy O’Connell, one of our senior analysts on the corporate team, and Gabe Diederich, one of our senior portfolio managers on our municipal team.

  We’ve been wanting to do this for a while. We’ve had a lot of questions from clients about the whole AI and data center buildout.

  This has been a really big deal for the bond market. Admittedly, the war in Iran has kind of overshadowed that a little bit, but that’s still been going on in a significant way.

  So we wanted to get together and talk about it, and a lot of that issuance has been in the corporate market.

  Andy, can you just talk to us a little bit about the scale and the pace of what we’re seeing here? This is unprecedented.

  Andy O’Connell:

  Yeah. This is going to be a really big deal. The AI innovation cycle will be transformational.

  There’s a real race for dominance going on right now. There are many players participating, and the spend that we’re seeing is really unprecedented, with estimates as high as $8 trillion over a five-year period through 2030. So significant spend over a short period of time and a lot of companies involved. It’s going to be significant.

  For us, as we’ve been evaluating opportunities, we think it’s really important to think about what lens you’re investing in. The lens matters whether you’re an equity holder or a bondholder.

  As bondholders, it’s important because at the end of the day we’re looking to get our principal back plus a spread over U.S. Treasuries.

  For equity holders, they might be getting multiples over their investment over a long period of time.

  So for us, it’s important to keep that lens as we’re evaluating opportunities.

  Overall, given the risk and the early stage that we’re in right now, we’re a bit more cautious, but we are looking for opportunities.

  This is almost like the space race from decades gone by. It’s an international race. The U.S. is racing with China and other players, but there’s also a domestic race between different companies.

  Warren Pierson:

  Are there going to be winners and losers, and how does that factor into our view?

  Andy O’Connell:

  There will be significant winners, and this will transform the economy and markets overall. But at this early stage, trying to predict who those winners and losers will be is very difficult.

  Right now, it’s many different players moving at tremendous speed across different asset classes. They’re raising billions of dollars in a short period of time.

  What we’re seeing in our space comes in two main flavors. One is the hyperscalers, the Googles, Amazons, Microsofts. They’re coming as senior unsecured issuance.

  Historically, these have been companies with strong balance sheets, high ratings and significant cash. Now, as they increase spending, they are coming to market more frequently and at larger size.

  For us, at current spread levels, particularly with high-quality issuers, we’re coming to the conclusion that we’re not getting paid enough.

  The other type is off-balance-sheet project deals to fund data centers. These are highly structured deals. Each one is different, with different characteristics. Some are issuer-friendly, some more creditor-friendly. We’ve been spending a lot of time analyzing these.

  That’s where cross-sector conversations are helpful, bringing together the securitized team and credit team.

  Some of this issuance is happening in these markets because the securitized market might require more compensation or better protections.

  So we’ve been cautious.

  Warren Pierson:

  There’s been a fair amount of issuance on the structured side. Take us through that. What does it look like?

  Meg Dean:

  This is a great opportunity for our firm to recognize the strengths of both the credit team and the securitized team.

  The securitized side has been important to financing the data center buildout, but on a much smaller scale. Credit can absorb much larger deals and can fund projects while data centers are under construction.

  In the securitized world, including asset-backed securities and CMBS, we’re seeing issuance when data centers are fully financed or stabilized.

  A stabilized data center means it is fully constructed and fully leased. So it’s a different stage in the lifecycle.

  Early-stage data centers are largely being funded through the corporate market.

  Securitized deals have generally come at wider spreads because of complexity and smaller deal sizes.

  Warren Pierson:

  Talk about the risk. Is it global risk or deal-specific?

  Andy O’Connell:

  It’s both. We’re in the early stages of a rapidly evolving technology. We don’t know exactly what these assets will be worth five, ten or twenty years down the road. There’s a significant amount of capital being raised for something with uncertain long-term value. If we’re going to invest, we want adequate protections and appropriate compensation.

  On the hyperscaler side, these issuers are becoming a larger part of the benchmark. Historically they weren’t big issuers of debt, but that is changing. As benchmark-aware managers, we will continue to evaluate opportunities. We can afford to be patient. There will be more issuance across markets and asset classes.

  Warren Pierson:

  There’s a lot of demand and deals are getting done. Are we missing something?

  Andy O’Connell:

  There’s a lot of excitement in the markets and strong demand.

   

  We think there’s also a somewhat simplistic view being taken, where people see this as Microsoft debt or Amazon debt without digging into the specific deal structure.

  We’ve already seen meaningful changes in deal structures in a short period of time.

  These project finance deals continue to evolve.

  Digging into the details matters.

  As structures become more investor-friendly or compensation improves, it becomes more attractive.

  Meg Dean:

  On the securitized side, the largest issuance years are ahead of us. It’s about patience and evaluating risk-adjusted opportunities.

  We invest at the top of the capital structure and prioritize high-quality liquidity. Most data center securities are Single-A rated due to limited performance history. There have been some Triple-A deals, but they are limited. This reflects the lack of historical data.

  There are also risks related to refinancing, tenant turnover and lease structures. We are not seeing sufficient compensation for those risks today.

  Warren Pierson:

  The municipal market hasn’t been directly involved in financing, but it plays a role. Gabe, how?

  Gabe Diederich :

  The municipal market is involved in infrastructure. That includes roads, water and sewer, but the biggest component is electricity. Electric-related spending has already increased over the last three years and will continue to grow. Some estimates suggest the next five years could be double what we’ve seen over the last decade. That includes power generation and transmission.

  At the local level, these can become major taxpayers, similar to large factories. Many of these are in rural areas and still in early development stages. We’re watching closely.

  We benefit from being able to collaborate with the credit and securitized teams.

  There’s also evolving public sentiment. Initially, municipalities welcomed these projects for tax revenue, but now some communities are pushing back due to concerns about energy usage and local impacts.

  Warren Pierson:

  This is an evolving topic. It is massive.

  If we were equity managers, we might take a broader approach and accept more risk for higher upside.

  As bondholders, we’re focused on getting our principal back and earning a reasonable return. So far, we have not felt we are being paid adequately for the risk.

  It will be interesting to see how this evolves.

  Thank you for tuning in. We hope this has been helpful.

What AI investment means for fixed income investors

In structured markets, data center financing is emerging through more complex deal structures, often backed by individual assets. These require deeper analysis to assess protections, cash flow durability, and refinancing risk.

For the municipal market, financing is primarily tied to the infrastructural needs of data centers. Power generation, transmission, and impact on local services and resources introduce additional considerations around community impact and public investment.

All of these variables create opportunity and complexity that many investors are attempting to evaluate in real time.

Key Investment Considerations

From a fixed income perspective, the investment framework differs meaningfully from equities. The two chief concerns for bond investors should be principal preservation and earning appropriate compensation for risk.

While the AI infrastructure investment opportunity is significant, we believe a measured approach is warranted for bond investors at this early stage in the cycle. The scale of issuance is expected to continue, which may present more attractive entry points over time.

Baird Advisors Fixed Income Approach Emphasizes:

• Cross-sector collaboration across credit, structured, and municipal teams
• Detailed fundamental analysis of each structure and issuer
• Patience in evaluating risk-adjusted opportunities

Warren D. Pierson, CFA Managing Director Co-Chief Investment Officer

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Andrew J. O'Connell, CFA Managing Director Senior Investment Analyst

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Meghan H. Dean, CFA Managing Director Co-Lead Securitized Sector / Senior Portfolio Manager

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Gabe G. Diederich, CFA Managing Director Portfolio Manager

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