Fear is overpowering greed in the $7.6 trillion U.S. corporate bond market, with investors pricing in the biggest reversal in credit quality in more than two decades as the economy falters and Europe’s debt crisis worsens.

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

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

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

Luring Investors
The surge in yields is luring investors including Pacific Investment Management Co., manager of the world’s largest bond fund, which views debentures issued by banks as among the best investments. Guggenheim Partners LLC is “aggressively” buying high-yield bonds and views the widening in spreads as unwarranted.

“The balance sheets of corporate America are as strong as they’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 unlikely that even if we did have a recession, we would see a material increase in defaults.”

Elsewhere in credit markets, leveraged loans in Europe posted their biggest loss since Greece was first bailed out as the region’s slowing economy spurred selling of riskier assets. The cost of insuring government and bank bonds in the region fell from records.

Buyout Loans
Loans used to fund buyouts ended August down 3.1 percent from the end of July, at an average of 88.3 percent of face value. That’s the biggest monthly drop since May 2010, when Greece got the first of two bailout packages for 110 billion euros and loans dropped 3.8 percent, according to data compiled by Markit Group Ltd.

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

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

The Markit iTraxx Financial Index linked to senior debt of 25 banks and insurers decreased four basis points to 266 basis points, after earlier rising to a record 277 basis points, according to JPMorgan Chase & Co. The subordinated index was down 10.5 at 470.5.

Australian Swaps
The Markit iTraxx Australia index increased 7 basis points to 182.5 basis points, according to Nomura Holdings Inc. That’s on course for its highest close since July 2009, CMA prices show. The Markit iTraxx Asia index of 50 investment-grade borrowers outside Japan added 2 basis points to 164 basis points, according to Royal Bank of Scotland Group Plc.

The indexes typically rise as investors confidence deteriorates and fall as it improves. The contracts pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals 1,000 euros annually on a swap protecting 10 million euros of debt.

The extra yield investors demand to own U.S. investment- grade corporate bonds instead of Treasuries climbed to as high as 227 basis points on Aug. 26, the most since October 2009, before falling back to 221 to end the month, according to Bank of America Merrill Lynch’s U.S. Corporate Master index. Spreads widened from 166 on July 31.

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

Debt Burdens
Spreads expanded even as cash held by investment-grade borrowers stood at the highest in a decade last quarter and corporate debt burdens fell to 1.92 times earnings before interest, taxes, depreciation and amortization costs, from a peak of 2.2 times in the third quarter of 2009, according to JPMorgan Chase & Co. strategists.

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

With balance sheets bolstered and companies refinancing debt at some of the lowest absolute borrowing costs on record, Moody’s has raised its long-term ratings this year on 1.14 companies for each one it lowered, according to data compiled by Bloomberg. At the height of the financial crisis in the first quarter of 2009, downgrades outnumbered upgrades by more than 10 to 1.

‘Significant Deterioration’
“At no point in more than 20 years has the difference between credit spreads and the downgrade to upgrade ratio been larger,” Richard Salditt, a credit strategist in Deutsche Bank’s credit sales and trading group, wrote in a Sept. 1 report. “Simply put, current credit spreads are already compensating investors for a significant deterioration in credit quality.”

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

“The problem with the current level of yields on investment-grade corporate debt is given the rally we’ve had in Treasuries, despite the spread widening, the absolute rates are still relatively unattractive compared to other asset classes,” Minerd said.

Spreads Volatile
Europe’s still-unresolved sovereign debt crisis and concern that the economy is slowing is likely to keep spreads volatile, according to AllianceBernstein’s Shah and strategists at JPMorgan, who in a report last week maintained a target of 250 basis points for relative yields on investment-grade companies and said investors should hold less of the debt than their benchmarks.

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

“Most investment-grade corporate bonds and even the highest quality high-yield bonds have the balance sheets to handle ‘stall speed’ and even a mild recession,” Mark Kiesel, the global head of corporate bond portfolios at Pacific Investment Management, or Pimco, said last week in an e-mail response to questions.

In Europe, the European Central Bank began buying Spanish and Italian government debt last month to curb a surge in bond yields as contagion from the debt crisis that engulfed Greece, Ireland and Portugal begins to infect the region’s third- and fourth-largest countries.

“We’re going to remain quite volatile, because we have a lot of uncertainty,” Shah said. “There are opportunities in both investment-grade and high-yield, but you have to be underwriting to a higher standard.”

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