The sliding oil price could be the next subprime crisis

The price of oil is collapsing. And if it continues to fall, it could trigger a wave of defaults in the US. John Stepek explains why.

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When investors are reaching for yield', it's a sure-fire warning sign.

It's something that financial historian Russell Napier highlights in his interview with Merryn Somerset Webb this week (watch it hereif you haven't already).

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Past experience shows that when investors get desperate, they'll start lending money to any old enterprise with a good story, as long as it promises some sort of real' return.

When investors become that indiscriminate about where they put their money, you can be sure that something will happen to burst their bubble sooner or later.

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And the anoil price crash might just be the thing to do it.

Investors have been lending rather too freely to high-risk companies

If you buy an investment-grade bond, the main concern on your mind will be prospects for inflation and interest rates over the period of the loan. The chance you might not get your money back is certainly a consideration, but it's one of several. You'll be more worried about the return on your money, than the return of your money.

But if you buy a junk bond, it's very different. The main question should be: what are the chances that this company will default?

The thing is, investors seem to have been getting a little too relaxed about that question in recent years. Low interest rates and the hunt for yield have made it incredibly easy for all sorts of companies and countries to raise money at levels they would never have once dared dreamed of.

Of course, because interest rates have been low, it's been easy for most companies to service their debt. So default rates are historically low too.

And as always happens, investors have looked at the low default rate, and assumed that this pleasant situation will continue forever or for at least as long as their investment time-horizon is.

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So if a group of companies start going bust rather more rapidly than anyone expects, junk bond investors will be in for a nasty shock.

And that looks rather like what might happen in the energy sector right now.

How the falling oil price could trigger a wave of defaults in the US

as we discussed earlier this week

There are all sorts of reasons behind the decision. But it's at least partly a game of chicken. It's all about seeing who goes bust first Opec or their new rivals on the block, the US shale oil producers.

The problem for Opec is that many oil producers will keep pumping regardless of profitability, simply to maintain some cashflow. So while there may be a floor to the oil price, it could be quite a bit lower than where it is today.

So as a consumer of oil-related products, I'm quite happy with this state of affairs. However, I'd be getting a little worried if I'd loaned money to the energy sector.

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As the Financial Times reports, "massive investment by oil drillers and exploration companies in US energy and shale gas projects in recent years has been partly financed via cheap borrowing conditions across capital markets."

Ten years ago, energy debt' accounted for 4% of the US junk bond market. Now it's up to 16%.

The crash in oil prices has not gone unnoticed. The average yield on junk energy bonds has risen sharply (in other words, prices have fallen) compared to other junk bonds.

"Nearly a third" of that energy-related debt is now "trading so poorly, it currently qualifies as being classed as distressed', indicating a high likelihood of being restructured." As Deutsche Bank put it, the tanking oil price "could potentially deliver a volatility shock large enough to trigger the next wave of defaults".

Could this have a knock-on effect? Given that many areas of the market including stocks are historically overvalued, and bond market liquidity in general is being questioned (we'll come back to this next week some time), I wouldn't bet against it. Banks are also sitting on some loans that now can't be sold on to the wider market.

Subprime should have taught everyone that panic in one area of the market can rapidly spread to apparently unrelated ones, as the scramble for liquidity sees even quality assets being sold off.

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As one credit trader tells the FT: "Equities ignore at their peril what is happening in the junk bond markets. We have had a long run in credit and slowly but surely, when things turn it starts in the weakest part of the market".

It's certainly one reason to continue to be wary of overpriced US stocks.

The beneficiaries from anoil price crash

My colleague Matthew Partridge looked at some of the best opportunities for investors in India in MoneyWeek magazine earlier this month. Subscribers can read his piece here.Not already a subscriber? Get a free trial and your first four issues free here.

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