If you are looking for a reason for market weakness, here it is: High-Yield Borrowing Costs Climb.

Average yields for junk-rated debt relative to benchmark rates widened to 1,093 basis points yesterday, the longest streak of increases in more than three months, according to Merrill Lynch & Co.’s U.S. High-Yield Master II index. Alliance One International, a tobacco processor based in Morrisville, North Carolina, is offering $600 million of senior notes due in 2016, according to a statement distributed yesterday.

Investors expect the spread rally in high-yield credit has ended amid concern of a “protracted recession” with an above average default rate, Bank of America Merrill Lynch analysts led by Jeffrey Rosenberg in New York wrote in a June 22 research note based on a semiannual credit survey of 82 investors. Respondents expected the default rate for high-yield debt to peak at 13.4 percent during the first-half of 2010 or later, the analysts wrote.

“Our semiannual credit survey suggests investors are more overweight corporate credit than ever,” the analysts wrote. “While high-grade investors expect spreads to tighten by year end, high-yield investors do not.”

Two-Year Notes Draw Strong Demand

Bloomberg is reporting Treasuries Rise as Two-Year Notes Draw Strong Demand.

Treasuries gained for a third day as the government’s sale of $40 billion of two-year notes drew higher-than-forecast demand and speculation increased that the Federal Reserve will keep interest rates steady this year.

The auction, the first of three this week of a record $104 billion in notes, drew the most bids for a two-year sale since September 2007. A class of investors that includes foreign central banks took the biggest share of the securities in at least six years at the auction, which took place as Fed policy makers began a two-day rate setting meeting.

“People are coming to the realization that the Treasury market offers very good value in light of current economic conditions,” said Jeffrey Caughron, an associate partner in Oklahoma City at The Baker Group Ltd., which advises community banks investing $20 billion of assets.

The sale’s so-called bid-to-cover ratio, which gauges demand by comparing total bids with the amount of securities offered, was 3.19. At the May 26 sale it was 2.94, then the highest since September 2007. It averaged 2.48 for the past 10 sales.

Bonds are a good risk-free value if you think the economy will double dip,” said Michael Franzese, head of government bond trading for Standard Chartered in New York. “At these yield levels, there’s a lot of bang for your buck there.”

Treasuries certainly are not “risk free” but the odds of a double dip recession and lower treasury yields are high. Moreover, those expecting a further rally in high quality corporates may be mistaken. Finally, if the bottom in junk bond yields is in for a while, the risk of further selloff in the equity markets is also high, with the “flight to safety” trade back on.

Mike “Mish” Shedlock
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