Fitch: U.S. default rate up sharply in third quarter; 11 issuers defaulted on $7.1 billion in bonds

By Caroline Salls

Pittsburgh, Oct. 27 - The U.S. high-yield default rate moved noticeably higher in the third quarter, as both the number of companies defaulting on their bond obligations and the par value of bonds affected by the defaults topped results for each of the previous two quarters, according to a Fitch Ratings report. According to the report, 11 issuers defaulted on $7.1 billion in bonds in the third quarter, compared with a total of 11 issuers and $2.8 billion in defaults for the entire first half of the year.

The large bankruptcy filings by Delta and Northwest Airlines, in particular, pushed the quarterly volume tally to the highest level since the third quarter of 2003.

The trailing 12-month default rate ended September at 1.8%, up from 1.1% in June. In addition, through the third week of October, five issuers, among them Delphi Automotive, had defaulted on $2.7 billion in bonds, pushing the trailing 12-month default rate further up to 2.1%, which Fitch said is still quite low but above 2004's year-end rate of 1.5%.

"While economic and funding conditions remain relatively robust, the uptick in defaults in the second half of this year is not surprising," Fitch's Mariarosa Verde said in the report.

"Distressed companies in weak sectors were sure to be hit by the additional burden of high energy costs in 2005, and at close to negligible levels, the default rate was generally running at an unsustainable cyclical low in the first part of the year."

Despite recent headline defaults, Fitch reported that the current default rate, at roughly 2%, remains in benign territory and is set to end the year at a level significantly below the average, which is estimated to be 5.5% according to Fitch's U.S. High Yield Default Index. This is the second consecutive year to produce such results.

According to Fitch, a long period of consistently low defaults is not unprecedented. From 1993 to 1998, high-yield defaults averaged about 2% per year.

Fitch said it believes that negative developments have surfaced in 2005, which, despite the economic outlook, will put upward pressure on the default rate over the next year.

"Rating activity for U.S. high-yield issuers turned net negative once again in 2005 with par downgrades exceeding upgrades by a ratio of 1.4-to-1 year to date through September," Fitch's Paul Mancuso said in the report.

Weakest links show little improvement

Upgrades have been especially lackluster at the lowest rating levels, resulting in little improvement in the significant market concentration of these bonds, Fitch reported.

At the end of September, 16% of market volume was rated CCC or lower.

About 20% of new bond sales through September carried ratings of CCC or lower, up from 13.3% in 2004.

While defaults have remained low in 2005, Fitch said there is evidence that the defaults have taken a bigger bite out of returns this year than last year.

The weighted average recovery rate on 2005 defaults through September was 40% of par, falling below 2004's 62% of par.

In addition, Fitch calculated that defaulted issues were trading at a weighted average price of close to 78% of par at the beginning of the year before falling to 40% of par at default. This is in sharp contrast to 2004 defaults, which were trading at 67% of par at the beginning of the year and whose market price fell to just 62% of par upon default.

Fitch said the widening spread between prices at the beginning of the year and prices upon default in 2005 is a product of the market's appetite for risk, which, in 2004, in particular, pushed up prices of high-yield bonds across the board, even distressed issues in the CCC to C category.

Overall the first nine months of 2005 saw defaults from 22 issuers on $9.9 billion in bonds, compared with 26 issuers and $6.5 billion over the comparable period in 2004.

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