Fear is overpowering greed in the $7.6 trillion U.S. corporatebond market, with investors pricing in the biggest reversal incredit quality in more than two decades as the economy falters andEurope's debt crisis worsens.

While Moody's Investors Service raised the ratings on 12investment-grade companies in August and lowered seven, relativeyields on corporate debt jumped more than half a percentage point,the third-largest increase since at least 1989, Deutsche Bank AGstrategists say. At no point in at least 22 years has thedifference between bond spreads and the ratio of upgrades todowngrades been greater, according to Deutsche Bank.

The divergence between ratings and yield spreads underscores thedivision between investors over whether the slump will provefleeting or mark the end of a rally that produced returns of 46percent on average since 2008. The bulls bet that companies, whichhave $1.91 trillion in cash and other liquid assets on theirbalance sheets, can withstand U.S. unemployment at 9 percent andgrowing headwinds from Europe.

“There are some real tail risks to the global economy here, inthe order of what we saw in '08,” said Ashish Shah, head of globalcredit investments at AllianceBernstein LP in New York, whichoversees $210 billion in fixed-income assets. “Unlike '08, whenpeople were very slow to price in those tails, we're now at a stagewhere people have priced them in much more rapidly than we saw inthe past.”

Luring Investors
The surge in yields isluring investors including Pacific Investment Management Co.,manager of the world's largest bond fund, which views debenturesissued by banks as among the best investments. Guggenheim PartnersLLC is “aggressively” buying high-yield bonds and views thewidening in spreads as unwarranted.

“The balance sheets of corporate America are as strong asthey've been in over 30 years,” said Santa Monica, California-based Scott Minerd, the chief investment officer at Guggenheim,which oversees more than $100 billion. “It would seem very unlikelythat even if we did have a recession, we would see a materialincrease in defaults.”

Elsewhere in credit markets, leveraged loans in Europe postedtheir biggest loss since Greece was first bailed out as theregion's slowing economy spurred selling of riskier assets. Thecost of insuring government and bank bonds in the region fell fromrecords.

Buyout Loans
Loans used to fund buyouts endedAugust down 3.1 percent from the end of July, at an average of 88.3percent of face value. That's the biggest monthly drop since May2010, when Greece got the first of two bailout packages for 110billion euros and loans dropped 3.8 percent, according to datacompiled by Markit Group Ltd.

Loans backing KKR & Co. and Permira Advisers LLP's buyout ofGerman broadcaster ProSiebenSat.1 Media AG, listed under theinvestment vehicle Lavena Holding, led declines, falling about 25percent to 62.42 percent of face value, Markit said.

The Markit iTraxx SovX Western Europe Index of credit- defaultswaps on 15 governments fell three basis points to 323 basispoints, after earlier rising to an all-time high of 330.5,according to index administrator Markit Group Ltd. at 11 a.m. inLondon.

The Markit iTraxx Financial Index linked to senior debt of 25banks and insurers decreased four basis points to 266 basis points,after earlier rising to a record 277 basis points, according toJPMorgan Chase & Co. The subordinated index was down 10.5 at470.5.

Australian Swaps
The Markit iTraxx Australiaindex increased 7 basis points to 182.5 basis points, according toNomura Holdings Inc. That's on course for its highest close sinceJuly 2009, CMA prices show. The Markit iTraxx Asia index of 50investment-grade borrowers outside Japan added 2 basis points to164 basis points, according to Royal Bank of Scotland GroupPlc.

The indexes typically rise as investors confidence deterioratesand fall as it improves. The contracts pay the buyer face value ifa borrower fails to meet its obligations, less the value of thedefaulted debt. A basis point equals 1,000 euros annually on a swapprotecting 10 million euros of debt.

The extra yield investors demand to own U.S. investment- gradecorporate bonds instead of Treasuries climbed to as high as 227basis points on Aug. 26, the most since October 2009, beforefalling back to 221 to end the month, according to Bank of AmericaMerrill Lynch's U.S. Corporate Master index. Spreads widened from166 on July 31.

Relative yields on debt rated below investment-grade soared 172basis points last month to 730 and reached a 23-month high of 750on Aug. 26, based on the Bank of America Merrill Lynch's U.S. HighYield Master II Index.

Debt Burdens
Spreads expanded even as cashheld by investment-grade borrowers stood at the highest in a decadelast quarter and corporate debt burdens fell to 1.92 times earningsbefore interest, taxes, depreciation and amortization costs, from apeak of 2.2 times in the third quarter of 2009, according toJPMorgan Chase & Co. strategists.

“They have more liquidity, lower debt ratios and have prefundedmore maturing debt than has occurred in any time than before 1980,”said Guggenheim's Minerd, who isn't anticipating the U.S. will dipback into recession.

With balance sheets bolstered and companies refinancing debt atsome of the lowest absolute borrowing costs on record, Moody's hasraised its long-term ratings this year on 1.14 companies for eachone it lowered, according to data compiled by Bloomberg. At theheight of the financial crisis in the first quarter of 2009,downgrades outnumbered upgrades by more than 10 to 1.

'Significant Deterioration'
“At no point inmore than 20 years has the difference between credit spreads andthe downgrade to upgrade ratio been larger,” Richard Salditt, acredit strategist in Deutsche Bank's credit sales and tradinggroup, wrote in a Sept. 1 report. “Simply put, current creditspreads are already compensating investors for a significantdeterioration in credit quality.”

While relative yields on investment-grade debt have jumped,overall yields have barely moved over the past month because of arally in Treasuries as money managers sought the safety of U.S.government debt. Yields climbed as high as 3.83 percent on Aug. 24before falling back to 3.62 percent on Sept. 2, the same as theywere at the end of July, Bank of America Merrill Lynch index datashow. That's down from more than 9 percent in October 2008.

“The problem with the current level of yields oninvestment-grade corporate debt is given the rally we've had inTreasuries, despite the spread widening, the absolute rates arestill relatively unattractive compared to other asset classes,”Minerd said.

Spreads Volatile
Europe's still-unresolvedsovereign debt crisis and concern that the economy is slowing islikely to keep spreads volatile, according to AllianceBernstein'sShah and strategists at JPMorgan, who in a report last weekmaintained a target of 250 basis points for relative yields oninvestment-grade companies and said investors should hold less ofthe debt than their benchmarks.

The median estimate of more than 50 economists surveyed byBloomberg News is for U.S. gross domestic product to expand 1.7percent this year. That's down from 2.5 percent in a June poll.

“Most investment-grade corporate bonds and even the highestquality high-yield bonds have the balance sheets to handle 'stallspeed' and even a mild recession,” Mark Kiesel, the global head ofcorporate bond portfolios at Pacific Investment Management, orPimco, said last week in an e-mail response to questions.

In Europe, the European Central Bank began buying Spanish andItalian government debt last month to curb a surge in bond yieldsas contagion from the debt crisis that engulfed Greece, Ireland andPortugal begins to infect the region's third- and fourth-largestcountries.

“We're going to remain quite volatile, because we have a lot ofuncertainty,” Shah said. “There are opportunities in bothinvestment-grade and high-yield, but you have to be underwriting toa higher standard.”

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