A pronounced deterioration in credit conditions would likely have wider reaching implications in the future than in previous instances, cautions Fitch Ratings in a new report.

Fitch points out that unprecedented levels of liquidity and investor desire to capitalize on the sustained run of favourable operating conditions have been the catalysts for robust corporate debt issuance throughout Europe, the Middle East and Africa – particularly within the more developed markets. “Moreover, new sources of capital and the level of disintermediation have seen broader classes of creditors and debtors indulge their appetite for additional and diverse financial risk,” it added. As a result, any deterioration in credit conditions could spread further than it has in the past.

In its review of the EMEA corporate bond market, Fitch notes that while the existence of liquidity and extent of high-grade issuance might ameliorate any immediate credit concerns about a significant increase in defaults in 2007, there is mounting evidence to suggest that the market’s resolve will be tested more thoroughly from 2008. “A higher amount of lower rated bonds are due to mature from next year, coinciding with what the agency anticipates is a period where increases in interest rates have taken greater effect and more risk reflective pricing is being employed,” it notes.

Current growth in industrial bonds rated ‘BBB’ or below is close to 30% per annum, with those in the ‘B’ category around double the rate, thus providing scope for an increase in negative rating actions, if not defaults, should the credit markets turn, the rating agency said.

“Of note is the extent of speculative grade rated bonds outstanding within some of the more volatile or cyclical sectors,” remarked Jonathan Cornish, a senior director in Fitch’s Credit Policy Group and primary author of the report. “Bond maturities in 2007 are quite negligible, but in aggregate some €3.4 billion of bonds from these sectors alone will mature in 2008, with another €2.8 billion falling due in 2009. Of course, in the coming few years a great deal more loans also fall due for some of the less creditworthy borrowers,” Cornish added.

Fitch added that it recognises the growth in speculative grade bonds as being from a relatively low base and by maintaining such a pace it will not materially alter their percentage contribution to total bonds outstanding, given the market’s overall growth levels. Speculative bonds represent only a modest percentage of the market, given that bond issuance is predominantly investment grade.

The corporate bond market in EMEA has maintained double-digit pace throughout the decade: at end-2006, there was a total €5,914 billion in bonds outstanding (in the pool of rated bonds reviewed by Fitch), up €1,221 billion or 26% in the year, though less than the 34% average growth rate since 2000. Meanwhile, US$1,706 billion of syndicated and leveraged loans were added in 2006, following the US$1,531 billion written in 2005.

Competition in recent years between the loan and debt capital markets – particularly at the SG and low IG levels – had relaxed attitudes toward risk pricing and covenant protection, it notes. Although, it says that the recent market volatility has, if anything, reminded creditors of the need to remain vigilant in managing their exposures, “as and when the credit cycle turns any further relaxation of risk tolerance now could later see a boost in absolute levels of defaults and, importantly, also the loss severity on such instruments.”

“A contraction in the amount of additional capital available to the more vulnerable entities is expected to provide the impetus for a hike in defaulting borrowers. In previous instances of heightened and sustained volatility and/or less favourable operating conditions, lenders have tended to find solace among higher-grade credits, which typically means reduced levels of funding on offer to riskier credits” Cornish said.

Fitch’s report also highlights the clear distinguishing characteristics between the EMEA and U.S. corporate bond markets. Apart from EMEA comprising some 45 countries (but with a high concentration of exposure within key European markets), IG bonds and BFI bonds currently account for 98% and 86% of the total value outstanding in the former region against 82% and 49% in the latter, where industrial issuance is far more meaningful in the context of the overall market.