The U.S. high-yield default rate ended 2006 at 0.8%, down from 3.1% in 2005 and substantially lower than the long-term average annual default rate of roughly 5%, according to a new study published by Fitch Ratings.

While the default rate is expected to remain below average for the fourth consecutive year, Fitch believes that the very low default rate experienced in 2006 is not sustainable and that the risk of a spike in the default rate is substantially higher in 2007 than it has been in the past several years. “Profit growth is expected to slow in 2007, debt balances are rising, and investors are likely to become more discriminating going forward, focusing more intently on risk/reward attributes in a maturing credit cycle,” it says.

Recent trends are already beginning to point in this direction, the rating agency adds. Fitch’s most recent survey of the financial performance of a sample group of 260 U.S. high yield companies revealed that through the third quarter of 2006, debt had expanded at the highest annual rate in five years (up 12% year-over-year) as new issuance continued to shift away from refinancing as a use of proceeds and toward debt-financed, shareholder-oriented activities, such as leveraged buyouts and mergers and acquisitions. Debt also rose to support capital spending which for this sample group of companies grew 26% year-over-year.

“The double digit expansion in debt in 2006 was a substantial departure from either 2005 or 2004 results when debt moved either slightly up or was down year-over-year,” said Mariarosa Verde, managing director of Credit Market Research.

In addition, a recent Federal Reserve survey showed lending standards among bankers shifting to neutral in the latter part of 2006, a retreat from an earlier bias toward looser lending practices. This suggests that the days of easy money may have peaked, Fitch says.

“Beyond macroeconomic concerns, a wildcard weighing on the outlook for 2007 and 2008 is uncertainty surrounding the behavior of the new class of nontraditional U.S. fixed income investors, including hedge funds and foreign investors,” it says. “At issue is whether these investors, hedge funds in particular, will be tempted to move money out of fixed income strategies in order to pursue higher returns in the rebounding global equity markets. In the opposite way that liquidity magnified the positive economic effect in 2006 and kept defaults in check, any meaningful funding disruption could quickly push up the default rate, especially for the lowest rated issuers.”