Credit turbulence is back again as we commence March trading.

Though several segments of the global credit marketplace have improved since crashing last September, others remain largely dysfunctional or under pervasive selling pressure in the midst of a rapidly contracting economy and the threat of bank nationalization. With the exception of non-financial investment grade debt and municipal bonds, most fixed income markets are in negative territory this year after a brief post-crash rally in November and December.

Over the last 19 months I’ve commented at length on the developments occurring in the all-important credit markets; it’s significant to review how credit is behaving now as the Dow and other international markets breach important support levels this week.

LIBOR has Plunged but still Elevated

Although still elevated, LIBOR, or the London Inter-bank Offered Rate, has compressed from a crisis high of 4.88% in October to just 1.26% now. Overseas dollar lending rates have indeed plunged over the last four months and that’s a positive development, boosting inter-bank liquidity. But since mid-January, LIBOR has remained stubbornly high compared to the benchmark Federal Funds rate; typically 90-day LIBOR has commanded a 0.15% to 0.20% premium above the Fed Funds rate – far lower than today’s 126 basis point spread.

By far one of the most constructive developments in credit since December is the boom in high quality non-financial investment grade debt issuance.

Investors are hungry for quality fixed income securities. According to Dealogic, February ranks as the ninth largest month on record for dollar denominated investment grade debt issuance at $67 billion dollars. Even more impressive is this month’s deal-flow does not include any debt backed by the FDIC or Federal Deposit Insurance Corporation; companies are going to market without a government backstop.

The Fed’s Aggressively Buying Mortgage Debt

Another bright spot is the Federal Reserve’s commitment to GSE debt, or Government Sponsored Enterprises, like Fannie Mae and Freddie Mac. Both mortgage providers, suffering massive losses since 2008 are insolvent; yet both Fannie and Freddie are now unofficially backstopped by Uncle Sam.

The Fed, attempting to bring long-term mortgage rates down, has already purchased more than $100 billion dollars of agency debt since November. Investors in Fannie and Freddie debt have feasted on a rally since late last year ahead of the Fed’s buyback plan as yields have declined from a crisis high of 6% to about 4.3% now. Still, though refinancing activity has surged recently, new and existing home sales have collapsed and show no signs of a recovery any time soon.

From a universe of more than 20 fixed income barometers tracked in the Wall Street Journal, only three segments of credit are showing a positive return this year. These include municipal bonds, mortgage agency debt and high-yield or junk bonds. The latter, however after a big rally in early January, has started to sputter ahead of a big spike in default rates.

The best-performing segment of credit in 2009 thus far is the municipal bond market. After crashing last fall, municipal bonds have posted strong gains since January, up almost 5%. Munis, which provide tax-free income at the federal level, are a bedrock staple security for many conservative and income-oriented investors. Boosting the sector is the recent $787 billion dollar stimulus package passed by Congress last week whereby a chunk of funds will go to cash strapped states and cities.

Many states and municipalities are suffering from plunging tax revenues and a sharply contracting economy. Without federal assistance many cities and states would probably risk bankruptcy, including California, the world’s 8th largest economy.

Threat of Bank Nationalization Hits Bonds

The threat of bank nationalization has crimped the performance of bank issued bonds, including senior bank debt. Credit spreads for investment grade bonds have risen sharply since mid-February as fears mount over the possibility of bank debt defaults. Though typically secure even in a bankruptcy, including Bear Stearns and most of Lehman Brothers’ outstanding senior debt, the odds are growing that Citigroup and Bank of America will be nationalized before the year is over as losses continue to balloon. Investors are rightly concerned about how these bonds will be treated under government ownership and whether subordinated debt will default.

Senior bank debt must not be allowed to fail. That’s because many global pension funds and insurance companies hold these securities and a default would seriously impact their portfolios and, ultimately, pensioners. The anchor for financing in the credit system is senior debt; if these bonds are allowed to default then it’s highly likely we’ll experience another crash in credit markets, not unlike what occurred in mid-September following Lehman’s collapse.

False Haven? Governments Bloated by Issuance

The United States and other economies, mainly in Europe, are now in the midst of a bull market in new debt issuance to finance massive bailouts and fiscal spending plans. And despite claiming to be a “safe haven” since last July, U.S. Treasury markets have corrected sharply since hitting all-time highs in December as investors reduce their holdings.

Global investors have started to place a risk premium on long-term Treasury bonds as yields continue to rise. Treasury has been successful selling short-term debt but has struggled to finance longer term debt since January.

Chinese and Japanese trade surpluses – responsible for almost half of Treasury purchases – will decline markedly this year as global trade contracts sharply. This leaves a possible funding gap ahead of $2 trillion dollars of debt issuance in 2009 (October 31 fiscal year) at a time when most foreign economies are likely to direct any surplus cash to domestic markets to finance their own bailouts and spending packages.

According to J.P. Morgan, the $2 trillion dollars in Treasury auctions this fiscal year will rank as the largest calendar year for sales – more than 13 times the amount the government raised in 2007.

Place Stop-Losses

Unconventional in normal economic periods, investors rarely apply a stop-loss on bonds. That’s due to the low level of volatility generally associated with fixed income securities. Yet, since late 2007 the credit crisis has completely changed the profile of risk adjusted returns as the economy nosedives, companies go bust and the government attempts an unprecedented and far-reaching bailout of key industries, namely banking.

With the rules of the marketplace now subjected to sudden change, investors must apportion a stop-loss on bonds. There’s no guarantee in this environment that senior bank debt will be covered by the federal government in the event of nationalization; bondholders might suffer the same consequences as shareholders.

Since last September the entire gamut of fixed income markets have experienced unusually volatile trade; in order to protect your capital I suggest placing a 10% stop-loss on all bond purchases. This applies even to Treasury securities, mortgage agency debt, municipal bonds and investment grade debt. I would still avoid high-yield bonds and emerging market debt altogether.

The rules of the marketplace are changing rapidly. Since nobody alive has experienced a severe debt deflation, it’s time to protect your fixed income holdings from the possibility of another crash in credit markets.

What’s truly alarming is that even government issued debt might not be immune to downside volatility as funding gaps continue to rise in the West from reduced or failed bond auctions. No country is immune – not Germany or even the United States, particularly on longer dated securities. Protect your bonds now.