UBS has been keen to warn investors about just how perilous the situation in high yield has become - which works out nicely, because we’ve been saying precisely the same thing ever since it became readily apparent that between investors’ hunt for yield and energy producers’ desire to take advantage of low rates and forgiving capital markets in order to stay solvent, the market was setting up for a spectacular implosion. 

Lots of supply (hooray for record issuance!), a gullible retail crowd (bring on the secondaries and find me a junk bond ETF!), and a lack of liquidity in the secondary market (down with the prop traders!) have conspired to create a veritable nightmare scenario and with commodity prices (especially crude) set to remain in the doldrums for the foreseeable future, the question is not whether there will be defaults in HY energy, but rather what the fallout will be for the broader market. 

Or, as we put it in "The Junk Bond Heat Map Has Not Been This Red In A Long Time," at some point, investors (using other people's money) will tire of throwing good money after bad hoping to time the bottom tick in oil just right (and if oil tumbles in the $30, that may be just that moment) at which point the commodity capitulation which we noted previously, will spread away from just commodities and junk bonds, and spread to all sectors and products, including stocks. 

Here with more on the contagion risk from commodities defaults is UBS.

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From UBS

Credit contagion: why commodity defaults could spread

In the wake of the commodity price swoon one of the recurring questions is will the stress in commodity markets spillover to other sectors? 

First, regular readers will recall our HY energy default forecast of 10-15% through mid- 2016. Simply framed, the commodity related industries total 22.8% of the overall HY market index on a par-weighted basis. In our view, sectors most at-risk for defaults (defined as failure to pay, bankruptcy and distressed restructurings) total 18.2% of the index and include the oil/gas producer (10.6%), metals/mining (4.7%), and oil service/equipment (2.9%) industries. 

How large are contagion risks to the broader HY market? And what are the transmission channels? Historically, investors in the limited contagion camp would probably point to the early 1980s. In this cycle commodity price defaults spiked with the drop in oil prices yet average default rates (IG & HY) increased only moderately amidst a favorable economic environment. In our view, however, the parallels in terms of the credit and asset price cycles are a stretch versus the current context. In the last three cycles, commodity price defaults have either led or coincided with a broader rise in corporate default rates (Figure 2). 

But why should there be contagion from commodity sectors to other segments?

There is a clear pattern of default correlation dependent on fluctuations in national or international economic trends. Commodity price weakness is symptomatic of weak economic growth in China and emerging markets – with possible spillover risks for commodity related sovereigns (oil exporters) and corporates.

In addition, distress in one sector affects the perceived creditworthiness as well as profits and investment of related firms in the production process. For example, exploration and production firm defaults could negatively affect suppliers and customers which would include oil equipment and service, metals, pipeline, infrastructure, and engineering firms. Furthermore, related literature points to the significance of the supply/demand balance for distressed debt; our theory is that there is a relatively finite pool of capital for distressed assets, implying greater supply of distressed paper pushes down valuations of like assets. Unfortunately, a rise in the supply of stressed bonds typically coincides with a decline in demand for such assets. This self-reinforcing dynamic historically leads to a re-pricing in lower quality segments.