Moody’s Investors Service reports that the default rate among speculative-grade corporates fell from 1.80% in 2005 to 1.57% in 2006, marking the fifth consecutive annual decline and its lowest year-end level since 1981.

The default rate for all Moody’s-rated corporate issuers fell to 0.54% in 2006 from 0.65% in 2005, the lowest level in a decade.

“2006 was an unexpectedly strong year for the riskiest corporate debt issuers,” says David Hamilton, Moody’s director of Corporate Default Research. “However, the credit quality pendulum appears set to swing in the opposite direction in 2007.”

Moody’s forecasting model for its speculative-grade corporate default rate predicts that the pace of defaults will nearly double over the course of 2007, rising from 2006’s 1.57% to 3.07% by the end of 2007. Moody’s speculative-grade corporate default rate has averaged 4.9% per year since 1983.

The rating agency’s report notes that a turn in the credit cycle, which was widely expected to occur in 2006, now appears much more likely in 2007. “Market liquidity was a crucial factor in keeping the default rate temporarily low in 2006, but we do not believe the relationship between fundamental credit quality and subsequent default rates has changed,” says Hamilton.

Hamilton points to the strong correlation between the timing of debt issuance and its initial credit quality and subsequent default risk. “The cohorts of risky debt issuance of 2003 and 2004 will soon be reaching the period when default risk has historically been highest, in the third and fourth years after issuance. Given the low average initial credit quality of these cohorts – many rated below single-B – default rates are likely to become higher in 2007 and 2008.”

Worldwide, Moody’s reports that a total of 33 rated corporate issuers defaulted on US$7.8 billion of bonds and US$3.1 billion of loans in 2006, compared with 34 issuers defaulting on a total of US$41 billion of debt (bonds plus loans) in 2005. The troubled auto parts sector experienced the highest volume of defaults in 2006 at US$2.8 billion – more than one third of the total defaulted bond volume for all of 2006.

The sharp drop in default volumes resulted in an equally sharp decline in the default rate measured on a dollar-volume basis. Moody’s dollar-volume-based speculative-grade corporate default rate fell from 3.85% in 2005 to 1.05% in 2006 as several large defaults in the airlines and telecommunications sectors in 2005 passed out of the calculation.

Moreover, corporate defaults were concentrated in the U.S. in 2006, where 26 corporate issuers defaulted on a total of US$9.1billion of bonds and loans in 2006. Five corporate issuers defaulted on US$1.6 billion of debt in Europe, and two bond issuers based in South America defaulted on a total of US$167 million.

Looking ahead, Moody’s warns that the expected turn in the credit cycle in 2007 is likely to lead to lower defaulted debt recovery rates. “Asset values – including defaulted bonds – are positively correlated with the economic and credit cycle. Moody’s forecast for rising default rates suggests that debt recovery values may have peaked,” says Hamilton.