Bond Boss: why ChatGPT might be affecting your bond fund

What does ChatGPT have to do with bond yields? 

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

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Yet the artificial intelligence (AI) boom may be helping to push bond yields higher.  

If you own a bond fund, that’s 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 stubborn than expected. Maybe central banks are keeping interest rates higher for longer.  

Or perhaps stronger economic growth is prompting investors to demand a greater return from bonds. 

All those factors matter. 

But there is another story unfolding in the background. It has less to do with inflation and more to do with something economists have pondered over for centuries: supply and demand. 

Too many borrowers, not enough lenders? 

Governments and companies both need money.  

Investors provide that money in exchange for future interest payments.  

If more borrowers turn up, investors can afford to be choosier. In many cases, they will demand a higher return before handing over their cash. 

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

Large budget deficits, ageing populations, rising healthcare costs and growing defence spending have all pushed public borrowing higher across much of the developed world. 

Governments have been issuing more debt and investors have been demanding higher yields to absorb it. 

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

Enter the AI boom 

Building AI infrastructure is expensive. Data centres do not come cheap.  

Neither do advanced chips, 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 the cash generated by their businesses.  

Increasingly, however, they are turning to the bond market as another source of funding. 

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

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In effect, governments now have more competition when they come looking for investors’ money. 

The question is: what happens when governments and some of the world’s largest companies are simultaneously issuing huge amounts of debt? 

Why this matters for bond investors 

The supply side of the equation is only half the story. 

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

Central banks are no longer buying 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 increasingly questioning whether bonds provide the same diversification benefits they once did. 

Put those trends together and a simple conclusion emerges. 

More bonds are being issued. Natural demand has become less dependable.  

If that additional supply outpaces investor demand, yields may need to rise to attract enough investors into the market. 

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

Good yields or bad yields? 

Not all rises 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 is generally a healthy development. 

After all, the money being borrowed today could help finance the technologies that drive tomorrow’s growth. 

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

The challenge for investors is that both forces may be operating at the same time. That is one reason why bond markets have become such a focus in recent months. 

What should investors watch? 

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 still need to borrow heavily. AI companies increasingly need capital too.  

Meanwhile, investors are becoming more selective about where they put their money. 

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Higher yields can also create opportunities. For example, shorter-dated company bonds may offer attractive income from coupon payments while being less sensitive to price swings than longer-dated debt. 

Investors should resist simply choosing the bonds with the highest yields, as those yields may reflect greater default risk.  

The more promising opportunities may lie among financially sound issuers whose bonds offer enough income to compensate for the risks, making careful selection especially important. 

Final thoughts 

ChatGPT is not setting bond yields.  

But the investment boom that AI has unleashed may be changing the balance between supply and demand in global bond markets.  

For investors, that extra 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. 

Jonathan Mondillo is global head of fixed income at Aberdeen.