Some of the most popular ways to hedge credit are breaking down just as concerns mount over the flood of artificial intelligence-linked debt.

Investors have long relied on credit-default swap indexes as a quick and liquid way to protect themselves against losses. But those benchmarks have failed to reflect a surge in risk premiums on corporate bonds, according to data compiled by Bloomberg. The widening gap means investors using the instruments to offset losses on their portfolios are getting less protection than expected.

“Weakness in AI-related credit relative to the broader performing market has led many investors to question which hedges are best suited for their portfolios,” Goldman Sachs analysts led by Amanda Lynam wrote in a note to clients on Thursday. “With so much focus on idiosyncratic risks tied to AI-related issuance and the funding arithmetic of the buildout, a key question is whether macro indices remain effective hedges,” they added.

The disconnect comes as trading in the world’s biggest credit market is increasingly focused on single-name credit default swaps tied to individual companies such as Amazon.com Inc., Meta Platforms Inc. and Alphabet Inc., whose historic borrowing binge to fund AI investment has created a new source of risk for traders. Hedging transactions work best when the underlying asset and hedging instrument are aligned in value.

“When you hedge cash credit with indexes, the starting valuation gap between the two matters,” said David Peacock, chief executive officer and co-founder at TabCap Investment Management, a hedge fund investing in credit indexes and related instruments.

The correlation between CDS and bond indexes has a history of fluctuating, making any hedges imperfect. However the breakdown of the tried-and-tested strategy now, as credit markets head for their first annual loss since 2022, may force investors to make greater use of alternatives.

CDS indexes like the CDX in the US and Europe’s iTraxx Crossover still attract trades worth tens of billions of dollars in notional volumes every day. Fund managers typically use them tactically to buy protection against the chance of their bond holdings going sour, though they have increasingly become tools for traders to bet on broader moves.

As AI fears mount, investors have preferred direct exposure to the dominant market factor rather than indexes that can move independently of their constituents. As a result, spreads on the CDX, which tracks the debt of 125 North American companies, have widened at less than a fifth of the pace of the US high-grade corporate bond index. The correlation between the two has fallen to about half its five-year average.

“All else equal, if single name CDS, not indexes, are the tool of choice then demand for bearish macro overlays via indexes might not jump as much,” said Marco Stoeckle, head of credit strategy at Commerzbank AG.

Listen: AI Bond Blitz Upends Investor Benchmarks It’s a similar picture in Europe, where the iTraxx Crossover index of CDS on mostly junk-rated companies has trailed a gauge of liquid sub-investment grade bonds. For every three basis points of widening in the junk bond spread in October, the CDS index spread gained less than one, based on data compiled by Bloomberg.

The absence of CoreWeave Inc — the so-called neocloud firm at the center of the most recent selloff in AI credit — has been a factor, while a regular update of the index’s composition in September was also significant.

TabCap’s Peacock described the European disconnect as “unsustainable,” saying it was “due to market technicals as much as anything else.”The gap has begun to revert to more typical levels recently, he added.

However, with market sentiment rising or falling with confidence in the AI trade, the distortion may persist for a while longer.

“I still think the single-name hedge still has some mileage left,” Stoeckle said. “The question is always against what and to which extent you need to hedge.”