Since peaking in October at 4.88%, three-month LIBOR, or the London Interbank Offered Rate, has plunged to 1.58% this morning. Although other credit indicators are mixed, a lower LIBOR rate is bullish for the short-term direction of credit markets and equities.

To be sure, this key lending rate affecting trillions of dollars in loans has started to finally track the decline in the Federal Reserve’s target Fed Funds rate. On Tuesday, the Fed cut its Federal Funds rate to a target range of 0.25% to 0%, even lower than the Bank of Japan’s current 0.30% target rate.

Despite the plunge in LIBOR lately most banks continue to hoard cash, including those institutions that have recently received government capital through TARP, or the Troubled Asset Relief Program. This suggests that even a lower LIBOR rate isn’t encouraging lending.

Meanwhile, the non-investment grade sector is still suffering as we shortly conclude 2008.

Funding for many companies in the high yield or junk bond sector remains largely elusive. Junk bond spreads are now at 16% above the ten-year U.S. Treasury bond yield – up from just 6% in September. I would still avoid junk bonds and emerging market debt. Default rates will rise in 2009.

Yet the spectrum for investment grade bonds continues to improve markedly since crashing in mid-September following the collapse of Lehman Brothers Holdings.

Investment grade corporate credit spreads continue to narrow since November. Combined with successful funding auctions over the last four weeks, including capital raised for some non-state guaranteed bank debt securities, investors are warming to investment grade credits.

I continue to recommend investment grade bonds for 2009. This sector should continue to recover ahead of other riskier credit indices. The yield flow from these bonds is attractive and bond prices are still roughly 10-15% below their pre-September highs.

Many financial sector bonds, now implicitly guaranteed by the U.S. government continue to offer attractive yields in excess of 500 basis points above T-bonds.

The Barclays U.S. Corporate AA-Rated Index has declined just 1% this year; the index now yields 6.25% compared to a multi-year high of 7.61% in October.

The Barclays U.S. Corporate Bond Index, a broader composite of investment grade paper, is yielding an effective 8.08% this morning compared to 9.09% in October. That’s a juicy 5.85% above ten-year T-bonds. This index has declined 7.8% in 2008 – its worst calendar year of performance since 1981.

Consider the risk/return profile now for investment grade bonds compared to stocks.

Over the last 20 years, the S&P 500 Index has returned only 2% more than the investment grade corporate bond market but accompanied by nearly three times the associated volatility. And over the last 16 months, I think investors have seen enough volatility to last a lifetime.

Why take on more risk in stocks when you can sit tight in corporate debt and get paid at least 6% while possibly securing some capital gains on any price appreciation?

It’s true that stocks have declined sharply over the last 12 months and might be poised for a massive bear market rally. Perhaps stocks are the better choice compared to corporate bonds. But if we’re heading into deflation, even a mild bout of falling prices, then look no further to the Japanese experience since 1990. There’s no assurance that stocks will hold above current levels – now up 21% off the November 20 low. Each rally since October 2007 has been met by a hungry bear taking stocks to new bear market lows.

Investment grade corporate bonds should be accumulated at these levels. The bargains remain abundant and yields north of 6% look pretty darn good in a low-to-no-yielding money-market and T-bill environment.