Fitch Ratings says it expects to see increasing defaults in the U.S. high yield bond market in 2006.

The rating agency notes that the market enjoyed another year of relatively low defaults in 2005. The default rate ended the year at 3.1%, above 2004’s 1.5% rate, but still well below the long-term annual average of 5.3%.

“The year’s results were uneven, however, with the first half of the year producing just $2.8 billion in defaults and the second half $20 billion,” Fitch points out. “In fact, the U.S. high yield default rate had contracted to a low of 1.1% in June of 2005 before ending the year at 3.1%. While both the defaulted issuer count and the par value of defaulted issues moved up in the second half of the year, the par value, in particular, rose dramatically due to a number of large high profile bankruptcies – Delphi, Delta, Northwest Airlines, and Calpine – to name a few.”

Fitch believes that similar to the latter part of 2005, there will continue to be upward pressure on the default rate in 2006. So far, Dana Corporation’s bankruptcy filing and several other defaults in January and February have pushed the trailing 12-month default rate up to approximately 3.3%, it reports.

“While any acceleration in the default rate is likely to be moderate in 2006, the benign default environment of the past several years is nonetheless beginning to show some signs of strain,” it says, noting that its new study offers a view of the key factors which are likely to have a meaningful role in the shift from a benign to a more challenging climate for speculative grade companies in 2006, and more so, in 2007. “Among these are slower economic growth, the re-emergence of the seasoning effect, and more difficult funding conditions,” it reports.

“While the overall prognosis for the U.S. economy remains positive, economic growth is expected to soften in 2006 and the cycle of corporate de-leveraging, which Fitch data shows already lost momentum in 2005, is expected to slow further and perhaps even reverse,” it says.

“In addition, new issuance has become increasingly more aggressive in recent years both from a use of proceeds and rating mix point of view and sooner or later this has consequences for defaults,” Fitch says. Its new study includes a look at the tendency for defaults to surface approximately three to four years after issuance. “The cumulative default rate for bonds sold in 2003, for example, reached 3.3% in 2005 – this over a period of roughly two years following issuance. In contrast, the cumulative default rate for bonds sold as recently as 2004 was 2.5% in 2005. Most telling, these figures were both noticeably higher than the seasoning pattern displayed to date by the conservative mix of bonds brought to market in 2002,” it notes.

“The more recent and more aggressive issuance pools have already begun to produce defaults at a faster pace than the 2002 class, a trend that is sure to continue,” said Mariarosa Verde, managing director, Fitch Credit Market Research.

“Finally, the other important pillar of low defaults, credit availability, is also likely to face headwinds this year as Federal Reserve rate hikes continue to push borrowing costs higher and create a more difficult funding environment for speculative grade borrowers,” Fitch adds. “Some of this was in essence already in play in 2005 as issuance shifted from high yield bonds to loans, a product not only of favorable borrowing conditions in the loan market but also of investor attitudes toward rising interest rates. While loan market conditions appear robust, any weakness in 2006 would disrupt a critical source of liquidity for high yield companies, especially those saddled with the most speculative profiles of ‘B-’ or lower. This is an especially meaningful concern given that high-risk receptivity in the loan and bond markets has very likely kept many low-rated issuers afloat in the past few years.”