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Fitch: U.S. Deep Speculative Grade Issuers Living on Borrowed Money, Time.

NEW YORK -- The U.S. high yield default rate ended 2006 at a historical low of 0.8%, down from 3.1% in 2005 and substantially lower than the long-term average annual default rate of roughly 5%. In addition, the weighted average recovery rate on the year's defaults reached a new high of 64% of par, up from 58% in 2005. Eighteen issuers defaulted on $5.8 billion in bonds in 2006 with two large defaults in the troubled automotive sector (Dana Corporation and Dura Automotive) contributing half of the year's default tally.

The historically low default rate combined with robust recovery rates produced a banner year for high yield investors in 2006. However, while Fitch believes that defaults will remain below average in 2007, the very low default rate experienced in 2006 is not sustainable and was due more to favorable funding conditions rather than credit quality gains.

In particular, the default rate among issuers rated 'CCC' or lower was unusually low in 2006. These issuers typically default at an average annual rate of 25% (based on number of issuers defaulting). While the default rate does fall during periods of strong economic growth, the 2006 default rate for these issuers of 4.5% (also issuer based) was the lowest in 20 years.

The easing of defaults among issuers rated 'CCC - C' was not due to a contraction in the number or volume of low rated issues. In fact, at the end of December, the pool of bonds rated 'CCC' or lower was $117 billion (16% of market volume), a level surprisingly high and above than the $105 billion outstanding at the end of 2005. The persistently large volume of 'CCC - C' rated bonds in combination with a historically low default rate suggests that liquidity more than fundamentals kept defaults in check.

For perspective, the risk of default among issuers rated 'CCC' or lower is high due to their precarious financial profiles. At the end of the third quarter of 2006, for example, Fitch found that the median ratio of EBITDA less CAPEX divided by Interest Expense was just 0.6 times (x) for a sample group of 'CCC - C' issuers, compared with a median of 1.9x for companies in the 'B' category and 3.5x for 'BB' issuers. In other words, 'CCC - C' issuers are generally only able to service their significant debt burdens by tapping external funding and have no cushion to sustain them if business or borrowing conditions soften.

In recent years, the insatiable demand for yield product among both traditional and more importantly, non-traditional fixed income investors, including hedge funds and structured vehicles, has clearly helped these companies get access to external capital with unprecedented ease and that has enabled them to avoid default.

'Without such optimal funding conditions and absent improving fundamentals, these deep speculative grade companies would have few options other than to restructure their debt', said Mariarosa Verde, Managing Director of Credit Market Research.

Fitch believes that given expectations for slower economic growth in 2007, the environment will prove more challenging for these issuers going forward and that their default rate will move more in line with historical experience which will push up the overall default rate. The most compelling evidence of a less favorable climate in 2007 comes from the most recent Federal Reserve's Senior Loan Officer Survey, which showed risk receptivity among bankers shifting to neutral in the latter half of 2006, a retreat from an earlier strong bias toward looser lending standards.

However, the outlook for the U.S. economy is still quite positive. Higher rated companies continue to report good financial results and enjoy strong balance sheets, and the market is still flush with cash, which Fitch believes will keep defaults overall below average. This outlook is very much dependent on Fitch's expectation for GDP growth of 2.4% in 2007, lower than 2006 but in a range that should keep defaults contained.

The outlook for 2008 is more cloudy as the business cycle continues to mature and the more aggressive deals brought to market in recent years begin to season, hitting that critical three- to four-year mark when post-issuance default rates for high yield issuers tend to peak. Fitch believes there will be a meaningful increase in defaults in 2008.

The 0.8% 2006 default rate marked the third consecutive year of below-average default rates. The default rate was 3.1% in 2005 and 1.5% in 2004. In addition, recovery rates on defaulted bonds have been running above the historical long-term average of 40% of par since 2004.

'The strong economic climate and general scarcity of distressed paper has boosted recovery values and this has further depressed the impact of defaults', said Paul Mancuso, Senior Director of Credit Market Research.

2006 Default Highlights:

--The par value of high yield bonds affected by defaults in 2006 totaled $5.8 billion, down substantially from the $22.8 billion recorded in 2005 (a year-over-year decline of 75%). The par value of bonds affected by defaults was the lowest volume tally since 1997's $4.1 billion. (In 1997 the U.S. high yield market was roughly a third of today's market size of $730 billion.)

--The number of issuers defaulting on their bond obligations contracted to 18 in 2006 from 33 in 2005.

--The year's largest default was the bankruptcy filing in the first quarter by auto supplier Dana Corporation which affected roughly $2 billion in bonds. In the fourth quarter, the bankruptcy filing by another auto supplier, Dura Automotive, added $811 million to auto-related defaults, bringing the sector's default rate to 6.5%.

--Defaults in 2006 were both low and showed no particular bias in terms of year brought to market. The average time to default for the small pool of 2006 defaults was five years, similar to 2005.

--The very low default rate in 2006 pushed the long-term average annual default rate down to 4.9% from 5.3% in 2005.

Fitch's complete analysis of 2006 default activity will be available in February on the Fitch Ratings web site at under the 'Credit Market Research' link.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.
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Publication:Business Wire
Date:Jan 10, 2007
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