From just 4.5% last year, the corporate default rate in the United States continues to rise rapidly this year amid a blizzard of bankruptcies. According to Standard & Poor’s (S&P), nearly 66% of nonfinancial companies have below investment grade ratings compared with 50% during the last downturn in 2002 and just 33% in the 1990 recession.

If history is any guide, the all-time high default rate in 1930 might be challenged in 2009 as scores of companies struggle to make ends meet.

Three of the largest credit rating agencies – Standard & Poor’s, Fitch’s and Moody’s – all project an average high-yield default rate of 14% this year or the highest default levels since 1930 when the country was in the throes of the Great Depression. In 2008, high yield or junk bonds crashed 25% - their worst calendar year performance in the post-WW II period.

On February 12, Charter Communications Corporation, founded by Microsoft co-founder, Paul Allen, filed for Chapter 11 as it sought to reduce the exploding debt on its balance sheet – now at $21 billion dollars. The company’s depressed stock market capitalization is just $15 million dollars.

Bull Market in Chapter 11 Filings

Over the last several months alone nine high profile companies have filed for Chapter 11, including Canada’s Nortel Networks, Circuit City, Chicago Tribune, Pilgrim’s, Verasun Energy and, the latest, Charter Communications. Many smaller companies have also failed under the weight of tight credit and plunging revenues.

What’s incredible is that the current default rate sits at just 4.5% - still historically low in consideration of the extent and duration of the ongoing credit crisis. That’s because many below investment grade companies refinanced at super low rates prior to the subprime credit explosion in August 2007; but now as the economy continues to viciously contract, sub grade borrowers are running into financing difficulties.

Also, private equity groups, which financed leveraged loans to many distressed companies earlier this decade, have also come undone as deals are cancelled or delayed in a tight credit environment.

Some of the worst industries in the ailing $14 trillion dollar American economy include media, entertainment, casino and hotel operators, auto companies and retailers, according to S&P. These sectors of the economy are bleeding heavily as their respective default rates surge. Incredibly, S&P projects nearly 90% of the 263 rated media and entertainment companies are at risk of defaulting this year.

1930 Meets 2009

In 1930, the worst credit bear market in history up until now, the U.S. corporate default rate hit a peak of 15%. Subsequent to the Great Depression, default rates hit 11.9% in 1991 and 10.4% in 2002, according to Moody’s.

At the end of 2007, the U.S. default rate stood at an all-time low of just 1%. The trend in defaults this year, however, is rapidly rising as the economy continues to bleed since last fall following the collapse of Lehman Brothers and the subsequent global stock market and credit crash that followed on October 9.

As of February 6, 21 American companies have defaulted on $43.1 billion dollars’ worth of bank debt – more than the combined value of defaults in 2006 and 2007. As the country tries to come to grips with how to recapitalize an insolvent banking system, rising defaults compound the enormous difficulties facing busted bank balance sheets and asset portfolios; many more speculative grade defaults lie ahead, hindering any recovery in bank earnings.

Rising Defaults and Junk Bond Prices

One of the worst investment ideas now is to accumulate junk debt. As tempting as some of these issues might be – offering more than 18% in some cases – the default rate will rise significantly this year. And historically, a rising or surging corporate default rate is bearish for junk bonds. You don’t want to lunge after high-yield debt amid a big spike in defaults.

As the economy continues to contract this year investors should instead focus on those segments of the credit market that are backstopped by the United States federal government.

Low Risk, Uncle Sam’s Guarantee

These include government-sponsored agencies (GSEs) like Fannie Mae, Freddie Mac, Sallie Mae and Ginnie Mae, TIPs or Treasury Inflation Protected Securities and senior investment grade bank debt. Though well above their recent lows last fall, these markets still offer high value, interest income and are backstopped by Uncle Sam, meaning current credit spreads might decline further.

For example, the Fed has already spent more than $90 billion dollars since last November to buy mortgage-backed agency bonds to keep mortgage financing rates affordable.

Another high risk area I would avoid, despite recent government support, is municipal bonds. U.S. cities, towns and states are now suffering from their worst economic contraction and funding gap since WW II. Several states are already virtually bankrupt - including California. Though the federal government at some point will provide support to these and other ailing cities and states, the risk is too high, especially on longer dated bonds. If you must buy municipal bonds because of your high marginal tax rate then stick to issues with maturities less than 36 months and monitor pricing at least weekly for any adverse changes or developments.

No Junk Bond Bailout

It’s highly unlikely the federal government will act as lender of last resort to speculative grade debt or junk bond issuers. These companies are already in credit turmoil while quickly depleting their cash reserves to finance bank loans and other liabilities. The odds of a federal government rescue for high-yield bonds or junk debt is virtually zero.

The United States is still in the early stages of a major spike in speculative grade defaults. Tight credit, plunging cross-border and domestic sales combined with a depression in domestic consumption don’t bode favourably for junk bonds any time soon. The sector should be avoided until the default rate reaches at least 10-15%, at which time I would begin nibbling at distressed bonds. Until then, focus on less riskier credit markets.