AI Credit Contagion: Why Software’s Meltdown Could Be the Next Big Risk for US Debt Markets

If there’s one thing markets love, it’s a good story about disruption. Lately, that story has a three-letter protagonist: AI. But as the AI narrative steamrolls through tech stocks, it’s leaving a trail of collateral damage that’s now threatening to leap the fence into the $1.5 trillion US credit market. Morgan Stanley’s latest warning isn’t just another analyst note to toss in the pile, it’s a shot across the bow for anyone still clinging to the idea that software is immune from the AI revolution’s darker side.

Let’s start with the obvious: software stocks have been getting torched. The AI-led selloff isn’t just a blip, it’s a full-blown regime change. The rotation out of legacy software has been relentless, with names that once traded at nosebleed multiples now looking like value traps. The carnage isn’t contained to equities. As Morgan Stanley points out, the tremors are rattling the credit markets, where software companies have long been treated as safe, cash-generating darlings. Now, the market is waking up to the possibility that AI isn’t just a growth lever, it’s an existential threat to entire business models.

The data tells the story: credit spreads on software debt have started to widen, and the usual suspects, those highly leveraged, slow-to-adapt incumbents, are seeing their bonds marked down. The risk is that this isn’t just a sector-specific hiccup. The software industry is a cornerstone of US investment-grade and high-yield credit. If AI-induced disruption triggers a wave of downgrades or defaults, the knock-on effects could be brutal. Think back to telecom in the early 2000s or energy in 2015. When a sector stumbles, the credit market doesn’t just shrug, it panics.

What makes this moment so fraught is the sheer scale of software’s footprint in US credit indices. According to Morgan Stanley, software accounts for a disproportionate share of BBB-rated debt, the lowest rung of investment grade. If even a handful of these names tip into junk territory, it could force a cascade of selling by funds that can’t hold high-yield paper. That’s how sector risk morphs into systemic risk.

And let’s not pretend this is just about AI eating the lunch of a few slow-moving dinosaurs. The entire software-as-a-service (SaaS) model is under scrutiny. Investors are asking hard questions about pricing power, customer stickiness, and the defensibility of recurring revenue streams in a world where AI tools can replicate core functionality at a fraction of the cost. The days of 40x forward sales multiples are over. Now, it’s about survival.

Meanwhile, the macro backdrop isn’t doing anyone any favors. US retail sales have stalled, and the much-hyped “jobless growth” era is here. That means less corporate spending on software, more pressure on margins, and, crucially, less room for error when it comes to servicing debt. The market’s willingness to look through short-term pain for long-term gain is fading fast.

To put it bluntly: the software sector is staring down the barrel of an AI-driven identity crisis, and the credit market is just starting to price in the fallout. If you’re a trader who thinks this is just another tech rotation, think again. The risk isn’t just lower stock prices, it’s a full-blown credit event that could spill over into the broader market.

So what’s the playbook here? For starters, keep a close eye on credit spreads for the big software names. When spreads start to blow out, it’s rarely just noise. Look for signs of forced selling in BBB-rated debt. If the downgrades start to pile up, the dominoes could fall fast. On the equity side, the days of buying every dip in software are over. This is a market that rewards selectivity and punishes complacency.

Strykr Watch

From a technical perspective, the software sector is teetering on the edge. Credit spreads for investment-grade software debt have widened by 30-50 basis points in the past month, a move that typically precedes equity underperformance. The iShares Expanded Tech-Software ETF (IGV) is hovering near multi-month lows, with RSI stuck below 40 and no sign of a reversal. On the high-yield side, the spread between BB and BBB-rated software bonds has hit its widest level since 2020. If you’re looking for a canary in the coal mine, watch these levels like a hawk.

The broader tech sector isn’t immune, either. XLK, the tech ETF, is flatlining at $143.807, unable to reclaim its 50-day moving average. Breadth is deteriorating, with fewer stocks making new highs. If XLK breaks below $140, the next stop could be $135. On the credit side, keep an eye on the LQD ETF for signs of stress in investment-grade corporates. A break below recent support would be a red flag.

The risk here isn’t just about price action, it’s about liquidity. If credit markets seize up, equity volatility will spike, and the rotation out of software could accelerate. This is a market that’s one downgrade away from a proper panic.

The bear case is straightforward: if AI adoption accelerates and software companies can’t adapt, earnings estimates will get slashed, and debt serviceability will come into question. The bull case? Maybe the market is overreacting, and the strongest names will emerge even stronger. But that’s a thin reed to lean on when the credit market starts to wobble.

For traders, the opportunity is in the dispersion. Short the laggards, own the survivors, and don’t get caught flat-footed if the credit market turns. This is a market that rewards speed and punishes hesitation.

Strykr Take

The AI-led software selloff isn’t just another tech tantrum, it’s a structural shift with real teeth. The credit market is waking up to the risk, and traders who ignore the signals do so at their peril. This is a time to be tactical, not dogmatic. Watch the credit spreads, respect the technicals, and don’t assume the worst is over. If the dominoes start to fall, the exit doors will be small and crowded. Strykr says: stay nimble, stay skeptical, and don’t buy the dip just because it’s there.