LIBOR rates are well below their clogged levels four weeks ago and U.S. corporate bond issuance in October witnessed a strong rally following a drubbing in September. Credit markets are definitely regaining much needed traction and investors should be encouraged by narrowing credit spreads.

Is it now safe to buy non-Treasury debt after a collapse of investment-grade and junk bonds since September?

After rallying for more than twenty straight sessions off their all-time highs last month, three-month LIBOR, or the London Interbank Offered Rate, has plunged from 4.84% to 2.23%. But despite this narrowing in the all important overseas short-term dollar lending rate, LIBOR has started to ratchet higher again over the last few days. This suggests that although credit conditions have improved since the global stock market crash on October 8-9, lending rates remain vulnerable to another squeeze.

Will TARP Survive?

The principal concern now is that U.S. Treasury Secretary Hank Paulson has changed funding guidelines and conditions for TARP, or the Troubled Asset Relief Program.

That announcement on November 12 tipped stocks into another major plunge as investors ponder what Paulson will do with the next tranche of taxpayer funds released by Congress; it also ended LIBOR’s four week rally as three-month overseas dollar rates bottomed at 2.13% and have since risen to 2.23%.

Initially, TARP’s $700 billion dollar bailout plan was designed to buy toxic and mostly illiquid mortgage-backed securities from bank balance sheets and transfer those assets into a fund or something similar to the 1989-1990 Resolution Trust Corporation (RTC) model for distressed real estate. TARP has now morphed into a till for banks and, on Wednesday, a credit backstop for consumers and, possibly, even Detroit’s struggling auto industry. Just who will get new funding and on what terms is a new uncertainty for investors.

U.S. 30-Year Auction Goes Poorly

The risk of systemic banking failure has not been eliminated. It has simply been transferred from the global banking sector to national government balance sheets. The risk associated with this transfer of toxic debt has resulted in sharply higher credit default swap rates (CDS), or the cost to insure government bonds from default. The cost to insure weaker government credits, like Belgium, Italy, Spain and Greece, has risen markedly since September as investors scramble to German and U.S. short-term debt.

But even U.S. Treasury debt has become more expensive to insure since September. Although it’s highly unlikely the U.S. would default since it creates its own fiat currency, the market has started to fix a higher risk premium to seemingly super-safe T-bonds. That’s not a good sign.

On November 13, the U.S. government’s auction of 30-year Treasury bonds received a disappointing bid, with Treasury sharply increasing the auction yield from an expected 4.22% to 4.31%. This suggests that we may be at the “beginning of the end” for long-term Treasury bids as a wave of new supply comes to market over the next 12 months to fund the financial sector bailout and, now, consumers, autos and possibly other strained industries.

German, European Auctions Struggle

Last week marked the first time in the post-WW II period that Germany failed to raise sufficient investor capital to finance a 10-year bond issue. Since October, Germany, considered the most liquid of European government bond markets, has scrapped four bond auctions because of tepid investor interest. And, since early October, several European government bond markets have also failed to successfully auction, including Austria, Belgium and Italy. Though less than America’s massive fund-raising requirements, European governments will nevertheless issue more than $1 trillion dollars’ worth of debt over the next 12 months to plug gaping holes amid a credit crunch and mounting bank recapitalization costs.

Corporate Bonds a Safe-Haven?

Maybe AA and A investment grade corporate debt is safer than government debt…

Corporate investment grade debt might be the new safe haven as this crisis lingers. That’s because corporate credit default insurance is cheaper than sovereign credit insurance; maybe the odds of the Italian or Irish government defaulting are deservedly greater than McDonald’s, Kraft Foods or IBM.

In September and October, investment grade corporate bond prices literally collapsed to levels unseen since 1980. The spreads between Treasury debt and investment grade corporate bonds now sits at 4.27%, down from an all-time high of 6.18% just two weeks ago. Credit spreads continue to narrow into mid-November.

The average total return on investment grade corporate bonds was a hefty 7.4% loss in October – the worst monthly decline since February 1980, according to Merrill Lynch.

Earlier, in September, strong credits, like IBM and General Electric Capital, struggled to secure favourable financing terms as the credit crunch hit the entire spectrum of borrowers – even AA credits. The good news is that U.S. corporate debt issued in October are now in the midst of their biggest rally in years, as investors lunge after their A and AA yields. IBM, for example, sold $4 billion of five, ten and thirty-year debt on October 9, a record amount for the American multinational. The Dow Jones Corporate Bond Index yields 8.08%.

Focus on Strong Credits

The credit crisis is showing signs of easing since October 10. Credit spreads for the riskiest debt compared to Treasury bonds has narrowed, new corporate bond issuance has increased and the commercial paper market has started functioning again, courtesy of the Fed’s assistance. LIBOR has also collapsed from its historical highs just a few weeks ago – a plus for interbank lending.

Still, risks remain. The market is unsure about TARP or another version of the Treasury’s bailout plan, the spectrum of rising non-investment grade defaults into 2009 and the possibility of a sovereign bond default in the emerging markets. Also, LIBOR has started to rise again since November 12.

Value investors hungry for yield should focus on investment grade corporate bonds, TIPs or Treasury Inflation Protected Securities and, for aggressive investors, convertible bonds. These three segments of credit offer exceptional values now for long-term investors.

Avoid emerging market debt and high-yield, or junk bonds, as credit spreads widen into 2009 accompanied by rising defaults. Yields might be tempting but are not worth the risk at this stage of the economic cycle. Also, long-term Treasury bonds are overvalued ahead of a boom in new issuance to pay for the ongoing bailout and, ultimately, a short-term stock market rally, which will siphon funds away from Treasury bonds.