"Why Commodities Defaults Could Spread", UBS Explains

Tyler Durden's picture

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. 

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Cognitive Dissonance's picture

Does a bear......ah, never mind.

<The answer to my unfinished question is...the bear shits wherever the hell (s)he wants to, just like the global bankster elite.>

Atomizer's picture

Does a negro blow climate change gas in the woods? Fixed it for you. Keep up the good work!

Lets Buy The Dip's picture

haha. Funniest comment I have heard today. 

China does not have a need for this stuff, as they are in trouble. 

However this week I keep watching the crazy stuff happening in CHINA. wow!

That HUGE STOCK MARKET crash in CHINA, Still happening has wiped many people out. OUCH! its lured in many novice traders who have quit their jobs,

Its roping in the little guy. 

 This novice farmer investor has basically lost his entire lifesaving’s and also his entire family fortune as well.Watch the video here ==> http://www.bit.ly/1fMcakI

Atomizer's picture

UBS, you're fucked. You have sometime to clean out the cubicle desk. The Feds will arrive.

nmewn's picture

UBS, worthless crony POS's.

JC-BI's picture
JC-BI (not verified) Jul 30, 2015 5:16 PM

3 more things:

1. Credit is too fluid thanks to the corrupt FED


2. The US economy has reached depression level which affects other economies

3. No confidence in the US dollar

kaiserhoff's picture

The corn belt is looking at another year of massive losses.

New crop projections within a whisker of last year.  That won't help.

knukles's picture

What about all them double secret triple over collateralized commodity backed loans with no collateral in China?
Will the downdraft in commodity prices hurt the loans when there's no collateral?
Kind of a rhetorical Tao of Pu question a la the Uncarved Block.

old naughty's picture

i take it you're saying no btfd...

some in-the-know in china, no?

bluskyes's picture

It will help those who haven't spent money they dont have to buy land they cannot afford.

are we there yet's picture

My 'ZH' link has becomre so filled with popups, slide bar freezes, and recover webpages that it is difficlut to use within the last few months. and it is getting worse. What has hapened?

jcdenton's picture

I use Pale Moon with Adblock and have yet to experience what you are describing. However, I will not be shocked when this really begins to happen ..


jmcwala's picture

Do you use Adblock/Adblock Plus?  Since installing Adblock plus, I get no pop ups or other problems.

Anglo Hondo's picture

Will the UBS mess spill over into the Clinton Foundation?  The answer is "no".

NOTHING touches the Foundation.

jcdenton's picture

And is UBS keen enough to inform us all they in fact fund ISIS?


Fahque Imuhnutjahb's picture



The question is when will the reserves of the banks held by the Fed. be deployed, and in what form?  Prop. desks are shut down, but loans to

Private Equity and Venture Capitalists aren't.  A significant portion of the QE conjured electrical bits/bytes have yet to be utilized, other than

buying up toxic assets--and then put right back in reserve,  It's my contention that once commodities and distressed assets are at

fire sale prices, these reserves will be deployed, and the injection of copious amounts of fiat will start the cycle again.

eeaton's picture

Any suggestions for a leveraged inverse high yield eft?

Pareto's picture

Terse but decent article.

James Grant has argued this often.  There isn't enough real collateral to cover drowning levered positions.  That is the essence of the contagion in that while HY defaults may be limited to a particular sector, say, oil and gas, the difficulty in making whole the debt obligation is a result of asset prices being bid way too high as a result of ZIRP.  In other words, there is a ton of debt sitting on assets whose "value" does not provide adequate security - especially under the possibility that they become distressed.  The contagion arrives from the necessity to sell "other shit" to cover short falls explicit in the HY default - that and the fact that there are so many ancillary sectors to oil and gas - also levered plays and also secured with over priced assets (thank you again ZIRP), so that the contagion sell is just exacerbated.


Its like what Grant said to Liesman back in Dec. of 2013, "the FED can change what things look like, but, the FED cannot change what things really are."  At the end of the day, price discovery will occur - a truck is just a truck.  A house, still just a house with all its attendant depreciation and maintenance costs.  When people like Druckenmiller, or institutions like UBS use the analogy of a "house of cards", or, "contagion", its because thats what it really is - just ask the folks at the $SSEC.


Its ironic (as it flies in the face on conventional economic theory - yet no surprise to ZH'ers), the very policy they are employing to encourage investment into business and so on with cheap non-existent interest rates, actually creates the opposite effect to bankers who have half a brain in their head.  They will actually lend less against the assets, not more, because while the price of the asset has increased (in some cases 10 fold) over the last few years, the attendant risk of failure of a business proposal remains the same, or has increased, given the uncertainty in economic growth and so on.  So the expected loss is actually greater than it would be if assets were priced against some benchmark like a market based (not FED set) interest rate.  Accordingly, banks are asking from borrowers to contribute more skin in the game (equity), simply because of the unsustainable asset appreciation.  It is simply getting increasingly difficult to price risk.  And its even worse for the borrower.


For example, in 2008 when the overnight lending rate was around 4% and the crash came, asset prices fell too - real hard.  But, this provided opportunities for many people who were looking to establish or expand their businesses - assets traded hands, bad debt was cleared, and we moved on.  Today, however, the over night lending rate is essentially zero.  So, asset prices have this binary characteristic.  You can get a good deal on a piece of shit, or, prices for something decent are still out of reach.  Its like ZIRP has created this environment where regardless of what the economy does, people are storing wealth in what they perceive as value and don't care how long it takes for shit to materialize, since there is no alternative to put their money.  Hence zombie companies with zombie assets.


Its fucking goofy.  Its fucking goofy because the FED ought to know this, but, unless you are on the ground, or in the trenches, I don't think you can ever know.


which is why central planning in general and the FED, the fucking FED in particular, can never really work.  - IMHO.

nevket240's picture

Sitting here, day over, watching the price of Gold get set up for the essential monthly close under $1084.  WaFJ.  Someone mentions a price and the DogFuckers oblige.


russwinter's picture

Sweet Spots in the Precious Metals Sector: