Slumping oil prices have left investors holding lower-quality energy bonds facing zero returns for the year and a rising tide of distress.

With US oil prices falling below $71 a barrel, attention has focused on the implications for the junk bond and leveraged loan markets.

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. Energy debt now accounts for 16 per cent of the US $1.3tn junk bond market, up from a share of 4 per cent a decade ago.

The pronounced slide in oil prices from a high above $100 a barrel in June, has been accompanied by a significant slide in prices for energy debt and with nearly a third of issuance trading so poorly it currently qualifies as being classed as distressed, indicating a high likelihood of being restructured.

Since the start of the year, the average yield for junk-rated energy debt has risen from 5.67 per cent to 7.31 per cent, while total returns for the year hover at 0.13 per cent. In contrast, the overall junk bond market has a total return for 2014 at 4.17 per cent, after a price loss of some 2 per cent.

Martin Fridson, chief investment officer at Lehmann Livian Fridson Advisors, said the drop in energy debt prices this year has effectively wiped out the 6 per cent coupon paid by the paper and adds “energy is heavily over-represented in the distressed segment” of the junk market.

Currently, 180 junk debt issues in Bank of America Merrill Lynch high-yield index are trading at very low prices, representing 7.9 per cent of the overall market, said Mr Fridson. Within the current distressed sector of the market, energy accounts for 52 issues, a share of 28.89 per cent.

The pressure on the junk market has come as the broad US equity market has continued rallying into record territory. During the near six-year bull market for risk assets, prices for both low-rated debt and equities have risen largely together, with the current divergence becoming a major talking point among investors.

While the US default rate remains low, such a measure is backward looking and was also moribund in 2007 ahead of the financial crisis. Deutsche Bank credit analysts recently said that if oil drops to $60 a barrel it could be the catalyst that pushes some energy companies into trouble and sparks a rise in the US corporate default rate.

Some analysts are drawing a parallel with the telecommunications industry, which borrowed heavily from debt markets in the late 1990s and early 2000s. The boom did not last and a wave of telecoms bankruptcies caused pain for the wider financial sector.

“Equities ignore at their peril what is happening in the junk bond market,” said Jerry Cudzil, head of US credit trading at TCW. “We have had a long run in credit and slowly but surely, when things turn it starts in the weakest part of the market.”

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