Sept. 11 (Bloomberg) -- More than 30 percent of European high-risk, high-yield bonds are trading at distressed levels, the most in five years, stoking speculation defaults will rise.

Investors demand an extra yield over government debt of more than 10 percentage points to hold 53 of the 169 bonds in Merrill Lynch & Co.'s Euro High Yield Constrained Index. That's the biggest proportion of distressed debt since March 2003, in the aftermath of the Sept. 11 terror attacks and the dot-com crisis.

``Typically, those levels of distress would indicate that defaults are going to rise,'' said Karl Bergqwist, who manages the equivalent of about $500 million in high-yield debt at Gartmore Investment Management in London. ``We think there's much worse to come. Spreads could go a lot wider and defaults are undoubtedly going to go up.''

Defaults on European speculative-grade corporate bonds will climb to 2.3 percent in a year, from 0.7 percent now, near a record low, Moody's Investors Service said in a Sept. 8 report. Worldwide defaults will surge to 7.4 percent, from 2.7 percent.

Spreads on high-yield debt have widened as investors, fleeing the fallout from the collapse of the U.S. subprime- mortgage market, shun all but the safest bonds and as banks tighten lending standards. The average yield in the Merrill High Yield index, an indication of the absolute cost of debt to companies, is 12.4 percent, twice the level of last March.

Europe Versus U.S.

The spread versus government bonds in Europe is 844 basis points, matching the highest since March 2003, according to the Merrill index. In the U.S., where Moody's says defaults are already at 3.3 percent, spreads on the comparable Merrill index are 11 basis points higher at 855.

Europe's primary high-yield bond market has been effectively closed since July 2007, data compiled by Bloomberg show. Last year, companies borrowed the equivalent of $32.1 billion using such securities, with all but $5 billion in the first half. Now, amid spiraling money-market rates, investors are wary of speculative borrowers. High-yield, or junk, bonds are those rated below Baa3 by Moody's or BBB- by Standard & Poor's.

``If companies find it difficult to raise money in the bond market at the same time as banks are tightening lending, then the probability of default increases,'' said Guy Stear, a strategist at Societe Generale SA in Paris. ``That's the case even if the fundamental business is sound.''

Highest Default Rate

New York-based Moody's expects makers of durable consumer goods such as furniture, floor coverings and fridges to show the highest default rate in Europe. The companies with the largest share of bonds in euros at distressed levels are General Motors Corp. and its finance unit, General Motors Acceptance Corp., according to Bloomberg data.

In Europe, six bonds sold by chemicals companies and nine issues from financial firms have spreads above 1,000 basis points more than government debt.

Some bonds sold in the rush of the first half of 2007 are now distressed.

The 500 million euros ($697 million) of 7 percent notes due 2017 sold by Norske Skogindustrier ASA, the second-biggest newsprint maker, are at a spread of 1,035 basis points more than government debt, according to Royal Bank of Scotland Group Plc. The 125 million euros of 8.125 percent bonds due 2014 sold by Paris-based car rental company Europcar Group SA are at 1,446 basis points, RBS prices show.

Whistlejacket Capital Ltd., the structured investment vehicle managed by Standard Chartered Plc, defaulted on 45 million pounds ($79 million) of senior notes sold in June 2007.

`Leading Indicator'

Levels of distress are ``a leading indicator of future speculative-grade defaults with a lead time of roughly nine months,'' S&P analysts including Diane Vazza wrote in a research report published last month. ``A rising distress ratio is indicative of a stressful credit environment.''

The absolute number of bonds in the Merrill index quoted at distressed levels is the highest since November 2002 after banks reported losses and writedowns of more than $500 billion worldwide, almost half of them in Europe.

Increasing levels of distress ``will clearly be a problem as default rates are still very low for junk bonds,'' said Arndt Muthreich, head of credit research at Dresdner Kleinwort in London. ``If the worst-case scenario materializes, the wave of defaults might be worse than in 2001 and 2002.''

In November 2002, investors were willing to pay an average price of 74 cents on the euro for the bonds in the Merrill High Yield index. The securities carried an average Moody's rating of B1, four levels below investment grade. The average price of the current index is 80.7 cents and the rating is unchanged.

To contact the reporter on this story: John Glover in London at johnglover@bloomberg.net

Last Updated: September 11, 2008 12:26 EDT