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Default danger for US high yield in 2016

After the bruising decline seen in high-yield bonds so far this year, dominated by the trouble for oil and commodity issuers, investors and analysts warn that the worst is still to come for the sector.

High-yield bonds are down around 5 percent so far this year, with estimates for junk bond returns in 2016 ranging from a loss of 3 percent to a gain of 6 percent, according to an annual, informal survey from S&P Capital IQ Leverage Commentary and Data (LCD).

Traders work in the S&P 500 options pit at the Chicago Board Options Exchange.
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Traders work in the S&P 500 options pit at the Chicago Board Options Exchange.

But investors should brace themselves for another wave of defaults in the U.S. oil and commodity high-yield sector with oil price hedges expiring next summer, according to chief investment officer of European high yield at Babson Capital Management, Zak Summerscale.

Energy future contracts allow oil companies to lock in prices for which it can sell it product ahead of time, protecting producers from some price volatility, but as these agreements expire, many of the U.S. shale producers could be exposed to lower oil prices.

"Energy and commodities are very tough to call given what has happened to the oil price. A lot of companies have hedged until next summer at much higher levels and I think if we stay around $40 (a barrel) mark I think you are going to have problems in the second half of next year as some of these hedges roll off and these companies don't have the cash flow to support their debt," Summerscale said.

Selling of junk bonds escalated after the shuttering of two Wall Street high-yield credit funds, Third Avenue and Lucidus, and the freezing of withdrawals from a third fund. Investors rushed to pull their money from these battered funds.

High-yield bonds, otherwise known as speculative grade or junk debt are bonds issued by companies that carry a rating of 'BB' or lower from Standard & Poor's or 'Ba' or below from Moody's. They have a higher risk of default compared to investment-grade debt but give a better return for investors as yields are higher.

"We don't think we have seen the height of defaults that you are likely to see in the energy and commodity space, but it is creating opportunities elsewhere because everyone is seeing the headlines in energy and everyone is selling high yield. So spreads are widening even from companies that are going to hugely benefit from a low oil price," Summerscale added.

Year-to-date returns, as of Monday December 14, are -5.15 percent, down from -1.44 percent at the end of November after the liquidity fears over U.S. funds, according to LCD.

There hasn't been a negative annual return since the massive loss of 23 percent in 2008 amid the credit crunch, according to the S&P U.S. High Yield Corporate Bond Index.

"The U.S. market, is about 20 percent oil and gas related and then if you add the mining and the capital expenditure, that supports both of those industries. It is starting to become a pretty significant part of the market - and that's why people are concerned," Head of European Leveraged Finance at Fitch Ratings, Edward Eyerman told CNBC Tuesday.

Eyerman noted that a major risk is the number of issuers with both dollar denominated debt and euro denominated debt, with contagion from the former into the latter. He added that this could lead to general weakness in the European high-yield space.

"If you have got a tranche in the U.S. that is pricing out because investors are selling high-performing assets in order to avoid recognising losses in oil and gas, the euro tranche will have to price up with the dollar tranche and so the cost of debt rises irrespective of what (ECB President Mario) Draghi can do," Eyerman said.

"I am not saying there is an event coming, but I am saying our liabilities are riskier than what most people appreciate. We don't have any maturities for 3 or 4 years, there is plenty of liquidity on balance sheets, but most borrowers have put themselves in the position that the need the capital markets to be in the same condition as they are today as in 3 or 4 years and that is where the risk has built up," he added.