July 7 (Bloomberg) -- The rally in junk bonds of the most debt-laden companies makes the market “incredibly dangerous,” said Greg Peters, head of credit strategy at Morgan Stanley.

The extra interest investors demand to own high-yield, high-risk debt implies a default rate of 13 percent this year, slightly less than forecast, even as average debt relative to earnings surges to an 11-year high, Peters said today in a conference call with clients. About 42 percent of junk-rated companies have at least six times more debt than earnings before interest, taxes, depreciation and amortization, he said.

The default rate on junk bonds may reach a record 18 percent this year amid a weak economy and “still difficult” capital markets, Fitch Ratings said today. A second-quarter rally in the most leveraged companies “worries us” and means investors should focus on borrowers with the most cash relative to debt, Peters said.

“I just don’t see the proper risk reward here,” said Peters, who is based in New York. “The bet that you’re making in high yield right now is that the consensus forecast for defaults is actually going to come in lower than anticipated.”

Given the increase in leverage, “that is a very tough bet to make,” he said.

High-yield bonds returned a record 23 percent in the second quarter of 2009 as investors speculated the worst of the recession was over, according to Merrill Lynch & Co.’s U.S. High-Yield Master II Index.

Narrowing Spreads

Spreads on high-yield bonds, rated below Baa3 by Moody’s Investors Service and less than BBB- by Standard & Poor’s, narrowed to 10.6 percentage points yesterday from an all-time high of 21.8 percentage points on Dec. 15, according to Merrill Lynch data.

The U.S. speculative-grade default rate should rise to a range of 15 percent to 18 percent by the end of 2009 from 9.5 percent in June and 2.4 percent a year ago, Fitch analysts led by Mariarosa Verde in New York said in a report. Recovery rates in early 2009 fell to 21.8 percent on bonds and 57.5 percent on loans, according to the report.

“The weak economy and still difficult funding conditions are having an unwelcome dual negative effect on credit losses -- driving up corporate defaults and simultaneously depressing recovery rates,” Verde, head of Fitch Credit Market Research, wrote in a statement accompanying the report.

To contact the reporter on this story: Bryan Keogh in New York at bkeogh4@bloomberg.net

Last Updated: July 7, 2009 15:35 EDT