Commodities junk debt faces more pain with contagion threat: UBS

New York

A PROLONGED slump in oil prices promises more pain for commodities-related debt and threatens to spread to other parts of the leveraged-finance market, according to UBS Group AG.

Energy bonds have borne the brunt of crude's plunge to a 12-year low, falling 10 per cent this year after a 24 per cent drop last year. With no end in sight to the oil slump, the market may not be adequately pricing in defaults or compensating investors for mark-to-market and liquidity risks for lower-rated junk companies, UBS strategists led by Matthew Mish wrote in a note on Wednesday.

"Given the significant widening in commodity spreads, is it the case that the market has largely priced in the risk? Not necessarily," Mr Mish said in a phone interview. "The linkage between commodity spreads and the underlying physical commodity is still very strong. Lower oil will trigger more stress and wider spreads." The premium investors demand to hold junk energy bonds widened to a record 19.3 per cent this month, compared with a five-year average of 7.6 per cent, Bank of America Merrill Lynch indices show.

Although energy credit yields have widened versus benchmarks due to the price stress, spreads are likely to increase further if oil remains low, wrote the strategists. An additional source of pressure is the "threat of an imminent, more severe wave of credit rating downgrades", they wrote.

A historical analysis of credit cycles shows that high-yield spreads in commodity sectors could reach up to 3,000 basis points in an environment in which oil prices stay low, Mr Mish said. The spread is now 1,870 basis points for metals and mining, the report said.

Credit markets are increasingly bipolar, the report notes, as "an overwhelming majority" of the re-pricing has been concentrated in a few industries. As a result, stressed spreads in the energy and metals and mining sectors "trade at valuations in the proverbial stratosphere" versus those of the broader high-yield market, according to the report. A continued slump in oil increases the risk that the pain will spread beyond the commodities markets, said Ramin Nakisa, a London-based UBS strategist who contributed to the report. BLOOMBERG