Montreal, Canada

One of the greatest asset reversals has occurred over the last three months with stunning velocity.

Junk bonds, or high-yield bonds, have seen their yields crash since peaking in early March from 17% to just 9.3% now, according to the Merrill Lynch-Bank of America High Yield 100 Index. The index has gained 17% in 2009 – better than U.S. stocks and other segments of risky credit.

According to Moody’s, the U.S. speculative-grade default rate on junk bonds surged to 9.2% in April compared to 8% in March and 2% a year earlier.

Moody’s, however, predicts the default rate will peak at 14.8% in the fourth quarter before declining to 10.4% twelve months from now.

Overall, 89 of the 112 defaults year-to-date were by North American issuers while European companies accounted for another 11 defaults.

With all due respect, these are the same guys that gave high credit ratings to mortgage insurers and a host of banks and investment banks with little or no tangible assets ahead of the credit crash in late 2007. I’m not sure the default rate will peak in the fourth quarter. In fact, I’m betting the opposite will occur.

Historically, the default rate on junk bonds has peaked at around 10-15% in previous post-WW II recessions. But this isn’t a normal recession; we’re still trying to climb out of the worst credit environment since the 1930s with banks mostly hoarding cash and the government still heavily involved in consumer and mortgage-backed lending facilities. This will not be a “normal” post-war recovery because credit expansion remains anemic.

More importantly, if credit to the best rated companies remains challenging then imagine what lies ahead for junk bond rated companies? This group has a tsunami of refinancing coming due from now until 2014 to the tune of $950 billion dollars. If the strongest credits are still struggling to raise capital and certainly paying a premium over short-term lending rates to secure that credit then it only seems logical that junk bond financing will struggle.

In other words, there’s an avalanche of defaults coming our way in the high-yield sector – assuming the economy isn’t in a new bull market. And historically, you never buy junk bonds when the default rate is still rising; still, as default rates have climbed markedly recently junk bond prices have soared. Something is wrong with this picture.

Bear market rallies are always convincing. The worst of the lot get swept away with the short-term trend making an ugly duckling look like a golden goose. This is still a very challenging macro credit environment whereby financing and refinancing trends have not returned to pre-crisis levels.

Yes, the government has done a good job masking the damage and insolvency of the banking system -- including fudging the accounting rules -- but now the real economy is next on the chopping block. This will be a much harder magic trick to follow. We’re nowhere near the end of this bear market in credit.

In the recent issue of my Accelerated Income I just issued a recommendation to short or bet against junk bonds – up 29% since the March low. Moody’s is wrong; the default rate will probably peak north of 20% in this cycle just like it did more than 75 years ago.

Have a good weekend. See you on Monday.