Why are credit spreads rising? Standard & Poor’s announced yesterday that the spread — or the difference between the rate for a Treasury instrument and a corporate bond of equivalent maturity — on speculative-grade bonds widened to 796 basis points, outside the 775 to 790 basis point range these issues have traded within for most of the year.

Spreads on securities rated triple C, the bottom rung of the credit-rating ladder, just hit a five-year high. The speculative-bond spread, according to Diane Vazza, head of global fixed income research at Standard & Poor’s, is up from 757 basis points at the end of July and 366 basis points a year ago.

Meanwhile, spreads on investment-grade debt have also widened to 283 basis points, 88% higher than the five-year moving average and 39% above the beginning-year level. The spread on investment-grade debt through August was 272 basis points, versus 165 basis points in the year-earlier period.

Spreads are important because they indicate risk: The wider the spread, the more risk associated with the corporate bond, and the costlier it is for companies to issue debt. Rising credit spreads are just as damaging to corporate America as higher taxes, and are confounding efforts by regulators to supply liquidity to banks and borrowers.

Corporate borrowers are frustrated that these spreads, or symptoms of insecurity in the bond market, are happening just as there are whispers of recovery. Consumer sentiment, for example, has improved for two months in a row, exceeding expectations, and the trend in home values no longer looks like an apple falling from a tree. Admittedly, house prices are still sinking, but the S&P/Case-Shiller index indicates a slowing decline, and the Commerce Department reports that sales of new homes hit a three-month high in July. Further, the painful climb in commodity prices has stalled, calming fears of inflation.

And yet, even as conditions begin to improve, credit markets are signaling profound unease.

Higher spreads have caused corporate borrowing costs to rise 30% from the beginning of the year, according to Ms. Vazza. Higher debt charges crimp profits and ultimately lead to reduced credit worthiness.

In other words, it is a vicious circle. The chief investment officer of Soleil Securities, Vince Farrell, points out in a note to investors that recent bond issues from some giant companies are proof of the toll being taken on corporate America — American Express just sold bonds yielding 7.34%, a level which would usually be reserved for a “junk,” or low-rated, issue. Similarly, American International Group recently had to offer investors 8.25% to get their bond sold.

Why are credit conditions worsening? Investment-grade paper is being battered mainly because of the impact of the financial sector. One fellow I spoke to, who manages a $5 billion hedge fund, says the real problem continues to be a lack of confidence in the assets held by financial institutions. His firm is buying mortgage portfolios from banks, as are numerous investors these days. However, the quality of the assets for sale makes even a hardened investor blanch, according to my hedge fund friend. He says that even the most prestigious institutions are holding shockingly poor-quality paper in their portfolios — and after all the revelations of the past year, he is not easily shocked.

Ms. Vazza also says the financials are the problem. “Nonfinancial investment-grade companies are able to borrow cheaper than investment grade banks; we’ve never seen that before. That disparity arose last November and has been sustained” she says.

However, the problem is also widening into the economy as a whole. “The market is also looking at rising corporate default rates overall, which have ticked up every month and which we expect to continue rising.”

The issue confronting speculative-grade spreads is different, according to Martin Fridson, the chief executive of a newly launched eponymous fund. He says the lowest rung on the credit ladder has been overvalued for some time, propped up, in his opinion, by hedge funds pressed by shrinking opportunities elsewhere. Now, he thinks those funds are beginning to pull out as they become concerned about default rates in a weakening economy. Since his firm is a potential buyer, he is delighted.

“We’re hoping that we’re beginning to see some capitulation,” he says.

Ms. Vazza points out that two-thirds of American nonfinancial corporations are speculative grade. As the economy slows, defaults in this arena begin to rise, putting upward pressure on spreads. “Ratings at the lower end of the spectrum are more volatile,” Ms. Vazza says. “The default rate quickly changes when the economy turns down.”

Admittedly, the corporate default rate until recently in this cycle was at an all-time low, so comparisons are bound to make for scary headlines. At the end of last year, fewer than 1% of all companies were defaulting on their debt; the number has since climbed to 2.4%, and S&P expects the number to rise to 4.9% by the middle of next year, or at least somewhat above the long-term average of 4.4%. Under a more pessimistic scenario, the researchers say that the rate could rise to 8.5% next year. In past recessions, defaults rose to more than 10% of all corporations, between 1990 and 1991, and again between 2001 and 2002.

The S&P group expects the current recession (what recession?) to bottom in the first quarter of 2009, but defaults lag the economy as a whole, and will likely rise through midyear.

“We see no real stability until 2010,” Ms. Vazza says. “The biggest issue is the cost of coming to the capital markets. Investors are worried about transparency.”

Indeed, so is S&P (some would say, “At last.”) The firm considers 22 of the 50 top-rated financials to have a negative outlook — the largest number in 15 years. Already, they have downgraded 31 such firms.

What can get us out of this mess? Better economic numbers, Ms. Vazza says. In other words, it’s the economy, stupid.

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