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There is a faint, but noticeable odor, from the corporate bond market that suggests something may be going bad–and on a day when global stock markets took a tumble it might be worth investigating. In January, the 12-month trailing rate of defaults in speculative grade debt in the U.S. rose to 1.39%, a 10% increase from the rate recorded in December 2006, according to a recent report from Standard & Poor’s. Worse, as the U.S. economy slows, S&P further projects that the default rate in these junk bonds will continue this rise throughout 2007, hitting 2.33%–up almost 7% over the year. And this is not even the pessimistic scenario: If the unemployment rate hits 5.6% (instead of the currently projected 4.7%) and corporate profits begin to decline, the default rate could almost double, to 3.52%, by yearend. While that number would still be below the long-term average default rate of 4.54%, it suggests a trend that won’t make executives or investors happy. S&P’s managing director Diane Vazza gives a 25% probability for the worst-case scenario to unfold.

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