(Bloomberg News) Morgan Stanley, JPMorgan Chase & Co. and Bank of America Corp. are recommending junk bonds as Europe's sovereign-debt crisis flares and concern mounts over the strength of the U.S. recovery.

Morgan Stanley said last week that U.S. high-yield obligations were in a "sweet spot" as borrowers cut their debt loads. JPMorgan said junk yields will fall more than half a percentage point by year-end. Bank of America favors debentures rated in the middle tier of speculative grade.

Gains on U.S. high-yield, high-risk bonds, which are little changed since the end of February, are set to accelerate as central banks respond more aggressively to contain Europe's fiscal imbalances, Morgan Stanley and JPMorgan said. While forecasting the default rate will rise this year, Moody's Investors Service says the figure will stay below historic averages.

"High yield is still providing attractive spread compensation, even adjusting for defaults relative to higher- quality credit," Adam Richmond, a high-yield credit strategist at New York-based Morgan Stanley, said in a telephone interview. "Certainly there are growing concerns surrounding Europe. We believe it's a somewhat different situation this year in part given more responsive central banks globally."

While the extra yield investors demand to hold U.S. junk bonds rather than government debt has declined 103 basis points this year to 620 basis points, spreads are still up from last year's low of 452 on Feb. 21, 2011, Bank of America Merrill Lynch index data show. Spreads soared to 910 basis points on Oct. 4, a two-year high, on concern the European crisis would drag the global economy into recession.

'Market Is Sound'

"Fundamentally the high-yield market is sound, with credit metrics fine and defaults very low," Peter Acciavatti, head of U.S. high yield at JPMorgan, wrote in a report last week.

Elsewhere in credit markets, Credit Suisse Group AG, Citigroup Inc. and Goldman Sachs Group Inc. are teaming up to bid on $7.49 billion of commercial-real estate securities the Federal Reserve Bank of New York took on in the 2008 credit crisis. JPMorgan is seeking to raise a $512.6 million collateralized loan obligation for Carlyle Group LP. Bonds of Petroleos de Venezuela SA were the most actively traded yesterday in the U.S. amid speculation that President Hugo Chavez's health is faltering.

Rate Swap Spreads

The U.S. two-year interest-rate swap spread, a measure of debt market stress, climbed 1.04 basis points to 31.17 basis points, the highest level since April 10. The gauge, which has expanded from a more than seven-month low of 23.5 on March 28, widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate bonds.

The cost of protecting corporate bonds from default in the U.S. rose. The Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, increased 1.2 basis points to a mid-price of 101 basis points in New York, according to prices compiled by Bloomberg. That's the highest level in a week for the index, which has risen from a one-year low of 85.46 on March 19.

In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings added 5.8 to 149.4. In the Asia- Pacific region, the Markit iTraxx Japan index rose 1 to 177 as of 9:36 a.m. in Tokyo, Citigroup Inc. prices show.

Loan Prices Rise

The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The New York Fed invited eight broker-dealers to compete for the so-called MAX CDOs after receiving "several" unsolicited bids for the holdings in its Maiden Lane III LLC portfolio, according to an April 10 statement. The other banks invited to bid are Barclays Plc, Deutsche Bank AG, Bank of America, Morgan Stanley and Nomura Holdings Inc.

The collateralized debt obligations, composed of two CDOs issued by Deutsche Bank in 2007 and 2008, could be sold intact or broken into pieces, though an interest-rate swap contract with Barclays would need to be paid out to access the underlying bonds, eating into profits, JPMorgan analysts said in a report last week. The consortium of the three banks is not looking to break up the deals, people with knowledge of the auction said.

Leverage Loans

The Standard & Poor's/LSTA U.S. Leveraged Loan 100 index rose 0.02 cent to 93.54 cents on the dollar, the highest since April 6. The measure, which tracks the 100 largest dollar- denominated first-lien leveraged loans, has returned 4.6 percent this year.

Leveraged loans and high-yield bonds are rated below Baa3 by Moody's and lower than BBB- by S&P.

The Carlyle Global Market Strategies 2012-2 CLO may include a $320.75 million slice rated AAA by S&P, two people with knowledge of the transaction said. Wells Fargo & Co. and Mitsubishi UFJ Financial Group Inc. raised a $509.9 million CLO for Carlyle last month, the third largest CLO, backed by widely syndicated loans, raised this year, Bloomberg compiled data show.

CLOs are a type of collateralized debt obligation that pool high-yield, high-risk loans and slice them into securities of varying risk and return.

In emerging markets, relative yields rose 4 basis points to 358 basis points, or 3.58 percentage points, according to JPMorgan's EMBI Global index. The measure has averaged 373 basis points this year.

Slower Junk Returns

Bonds of PDVSA, Venezuela's state oil company, were the most actively traded U.S. corporate securities by dealers, with 120 trades of $1 million or more, according to Trace, the bond- price reporting system of the Financial Industry Regulatory Authority.

Chavez, 57, spoke on state television yesterday for the first time since leaving for Cuba on April 13 to receive radiation therapy for an undisclosed form of cancer, saying that speculation about his health is likely to continue. PDVSA's $6.15 billion of 8.5 percent notes due November 2017 fell 1.16 cents to 86.1 cents on the dollar as of 5:05 p.m. in New York, Trace data show.

U.S. high-yield bonds have returned 0.05 percent since Feb. 29 after gaining 5.25 percent in the first two months of the year, more than the 4.38 percent in all of 2011, according to Bank of America Merrill Lynch's U.S. High Yield Master II Index. Junk bonds lost 7.46 percent in August and September of last year.

'Shock Absorber'

Returns are slowing as a backlash in Europe against budget cuts gains momentum and economists forecast growth is slowing in America.

Dutch Prime Minister Mark Rutte offered his cabinet's resignation amid a revolt against spending cuts. French President Nicolas Sarkozy lost the first round of his re- election bid as the anti-euro National Front won a record share of the vote.

In the U.S., while gross domestic product grew at a 3 percent pace in the last three months of 2011, it will slow to 2.3 percent this year, according to the median estimate of 74 economists surveyed by Bloomberg. Projections for GDP growth this year are slower than the 3.1 percent posted in 2005 and 2.7 percent in 2006 before the recession and financial crisis.

While headwinds that will hinder near-term gains for high- yield bonds are growing, the U.S. economy can still act "as a shock absorber, helping to offset the potential impact caused by changing European sovereign conditions," the JPMorgan analysts led by Acciavatti wrote in an April 20 note to clients.

The JPMorgan analysts forecasted junk yields will decline 56 basis points to 7 percent by the end of 2012.

B Tier

Returns on junk bonds may reach 6.3 percent for the rest of the year, Morgan Stanley's Richmond wrote in an April 20 note to clients, as "modest economic growth" pushes borrowers to trim debt levels, default rates remain below 3 percent and investor appetite for higher-yielding assets increases amid a "mild recession" in Europe.

Debt in the B tier of the ratings scale that's less exposed to the risk of rising interest rates compared with BB debentures and less vulnerable to default than CCC is attractive, Bank of America analysts led by Oleg Melentyev wrote in an April 20 note to investors.

"There are very few places in the fixed-income universe where investors could expect a similar degree of protection," the Bank of America analysts said of high yield.

While Moody's raised its year-end global speculative-grade default forecast this month to 3 percent from 2.6 percent after 11 companies defaulted in March, the figures compare with the ratings firm's long-term average 4.8 percent. The default rate was at 2.3 percent as of the end of the first quarter, up from 1.8 percent at year-end.

"It's the best asset to hold right now" unless Europe's crisis creates a "systemic risk," Kingman Penniman, chief executive officer of KDP Investment Advisors Inc. in Montpelier, Vermont, said of high-yield bonds in a telephone interview. "High-yield is a class that can absorb concerns in interest rates."