A “toxic combination” of economic and funding pressures has set in motion the beginning of a surge in U.S. high yield defaults that could turn out to be the worst period ever, finds new research from Fitch Ratings.

Fitch finds that the critical supports of low corporate default rates have deteriorated at an alarming pace in 2008 and believes that recent unprecedented events in the credit markets, along with a number of other factors, suggest the coming high yield default wave may be the most severe on record.

The rating agency predicts that the coming default wave will resemble the early 1990’s recession, with more industry sectors affected by defaults than in the 2001/2002 downturn due to the broader negative implications of depressed consumer spending, compounded by the leveraged buyout boom of 2004-2007 which pushed up leverage levels across many firms previously better capitalized to withstand a downturn.

“Economic weakness will continue to add to the pool of high risk borrowers,” said Mariarosa Verde, managing director of Fitch Credit Market Research. “Add tight credit to the mix and the result will either be a concentrated surge in defaults over the next two years or a protracted period of above-average annual default rates.”

The rating agency says that defaults tend to spike roughly one year following a meaningful contraction in corporate profit growth, and that this trend emerged in 2007, with corporate profit growth continuing to sink in the first half of 2008. “While high yield defaults have already begun their ascent, the erosion in corporate profit growth is expected to have its greatest impact in 2009 and 2010, exacerbated by continued difficult borrowing conditions,” it says.

Additionally, in July, nearly 60% of banks surveyed by the Federal Reserve reported tightening standards on commercial and industrial loans. Fitch notes that the last time risk aversion among lenders reached this level, in early 2001, borrowing conditions remained constrained for the next three years.

It also says that certain characteristics of the leveraged loan issuance boom of 2004-2007 may also have unintended negative consequences for credit availability. Fitch believes that the possibility of lower recovery rates on loans and bonds, resulting from the trend in recent years toward loan-heavy capital structures, may reduce refinancing opportunities for high yield issuers, as new lenders/investors will likely be put off by this additional risk factor.

On a year-to-date basis, the U.S. high yield default rate of 3.2% through September remains below the average annual default rate of 4.5%, but it has posted the biggest increase in several years, moving up from just 0.5% at year-end 2007 and 0.8% at year-end 2006, Fitch reports. The par value of U.S. high yield bond defaults also jumped to $25 billion through September, up from $3.5 billion for all of 2007.

“The number of issuers defaulting on their bond obligations more than doubled over the first nine months of 2008 relative to all of 2007, with 35 issuers defaulting through September compared with 15 in 2007,” said Eric Rosenthal, director of Fitch Credit Market Research.

IE