Fitch Ratings reports that U.S. high-yield bond defaults totaled just $1.5 billion in the first quarter of the year, down 61% compared with the first quarter of 2004.

The number of issuers defaulting also dropped 56% year over year. The trailing 12- month default rate, which ended 2004 at 1.5%, contracted to 1.1% in March. “The robust economic environment, together with excellent funding conditions, continues to favor high yield companies,” Fitch says.

However, it notes that the U.S. high yield market’s concentration of bonds rated ‘CCC or lower’ remains high, representing approximately 16% of market volume (or close to $110 billion) at the end of March. “The heavy load of lower rated issues was not helped by first quarter rating drift which on a par basis showed slightly more downgrades than upgrades, a reversal of the trend of more upgrades than downgrades established over the previous three quarters,” it adds.

“While current economic conditions remain solid and support below average default rates, the market’s considerable concentration of low rated issues suggests heightened sensitivity to adverse conditions of any kind,” said Mariarosa Verde, managing director, credit market research, Fitch Ratings. “The most significant risks include rising oil prices and the possibility of a slowdown in consumer spending prompted by higher interest rates.”

Fitch also notes that aggressive new issuance is adding upward pressure on default rates. “The issuance boom of 2002 – 2004 was mostly dedicated to refinancing which generally helped issuers by strengthening their balance sheets. However, in 2004, new issuance began to take on more aggressive characteristics as corporate conservatism gave way to growth oriented but higher risk activities such as acquisitions and leveraged buyouts,” it explains. “The trend has accelerated in early 2005 with Merrill Lynch reporting that in the first quarter nearly a quarter of proceeds from new bond sales were dedicated to leveraged buyouts.”

“While the state of the economy is ultimately the mother of all catalysts when it comes to default risk, nonetheless, an excess of funding activities which drive up leverage and business risk, by their very nature, create another layer of risk. At credit cycle peaks these activities have led defaults three to four years post issuance,” it reports.