Credit quality gains resulting from stronger economic growth and favorable funding conditions continue to dampen U.S. high-yield defaults.

According to a new survey by Fitch Ratings, financial trends through the second quarter revealed a growing number of companies reporting increases in revenue and decreases in debt year-over-year. As a result, the trailing 12-month default rate dropped to 1.5% in September, down from 3.2% in June and 5.3% at yearend 2003.

The value of bonds affected by defaults totaled US$1.2 billion in the third quarter and just six issuers defaulted on their bond obligations in the quarter. Both measures are down considerably year over year. The year-to-date default volume of US$6.7 billion is down 78% compared with the first nine months of 2003, and the defaulted issuer count of 27 through September is down 68%.

Three months in 2004 have produced zero defaults, and the default rate has dwindled to a level comparable to the boom years of the 1990s (spanning 1993 to 1998) when annual default rates fell short of 2%.

In the third quarter, the par value of bonds affected by upgrades in high yield once again exceeded downgrades, the second consecutive quarter to produce such results. In fact, the high yield sector has enjoyed the bulk of 2004’s upgrades, leading to a small but notable improvement in the market’s rating mix. The high yield sector is leading the credit cycle upturn, Fitch said.

Much of this is being prompted by the stronger economic environment. Fitch examined revenue and debt for a sample of 314 high yield issuers. The survey revealed a growing number of companies reporting increases in revenue and decreases in debt year over year. In the second quarter of 2004, 81% of the companies in the Fitch sample posted increases in revenue relative to the second quarter of 2003, and 58% of companies in the sample reported a year over year contraction in debt. Both of these measures were up from quarterly averages of 69% and 54% posting year over year increases in revenue and decreases in debt, respectively, in 2003.

The contraction in debt combined with top line growth boosts the ability to repay debt and suggests more upgrades. And, Fitch’s expectation of 3.6% U.S. real GDP growth in 2005 also supports low defaults moving into next year.

Fitch notes that funding conditions have continued to favor high yield issuers. New issuance through September totaled $140 billion, similar to the pace recorded in 2003. High yield companies have also benefited from the boom in syndicated loans this year, it says. Fitch says the most recent Federal Reserve survey of senior loan officers, reports that more banks have reported loosening credit standards than tightening in 2004, the first time that has occurred since 1998. The results of the survey have moved remarkably in step with the direction of defaults over the past decade with periods of tight credit associated with high defaults and periods of loose credit associated with low defaults, it says.