Fitch: credit quality warning system eroded by disappearing loan covenants

By Angela McDaniels

Seattle, Aug. 9 - One of the key factors influencing the direction and severity of corporate default rates is credit availability and, in particular, issuer access to funding in the loan market, according to a study released by Fitch Ratings on Wednesday.

In the study, Fitch examined the role of loan amendments and the observed relationship between loan amendment activity, the general direction of credit quality, credit availability and default patterns.

The study found that loan amendments offer a "valuable view of broad corporate credit quality trends," according to the agency.

"Watching loan amendment activity for individual firms can provide an important warning of financial distress and in the extreme, default or bankruptcy," William May, senior director of Fitch's credit market research group, said in an agency news release.

"Over the past decade, of those firms that defaulted with rated loans and bonds in their capital structure, one third had received a loan amendment within a few years of the bond default. In fact, 50% had received an amendment six months prior to the bond default and 75% one year prior to default."

From a macro perspective, Fitch said it found that in the last credit downturn, rising loan amendments preceded rising defaults in the high-yield bond market. Further, Fitch found that in six of the seven years examined in which loan amendment activity increased, bank lending standards tightened.

High-yield bond default rates, in fact, have historically followed a pattern remarkably similar to credit availability trends in the loan market, the agency noted, with consistently low default rates accompanying periods of loose lending standards on commercial and industrial loans and high default rates accompanying periods of tight lending standards.

"The loan market's risk appetite and willingness to extend credit is clearly important, however anticipating changes in the loan market's behavior is challenging," Mariarosa Verde, managing director of Fitch's credit market research group, said in the release.

"Loan amendment patterns overall may offer clues about the likely direction of risk aversion in the loan market which in turn has consequences for defaults."

The study also looks at covenant trends through the first half of 2006 and found that covenant packages continued to shrink in the first half of the year, calling into question whether the information content provided by covenants and related amendments is also fading.

The full report, titled "Credit Quality Warning System Eroded by Disappearing Covenants, A Look at Loan Amendments" can be found under the Credit Market Research link at www.fitchratings.com.

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