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* European junk CDS spread falls to Feb 2020 low
* U.S. junk bond yields eye record low
* Government bond rally supports credit markets (Adds details, context)
By Yoruk Bahceli
June 14 (Reuters) - The cost of insuring against European junk bond defaults fell to its lowest level since February 2020 on Monday and U.S. junk bond yields eyed record lows, as falling underlying rates fuelled a rally in credit markets.
Credit markets in recent sessions have gained alongside government bonds, which have shrugged off U.S. inflation data and rallied strongly thanks to short covering and a dovish outcome to last week's European Central Bank meeting.
The spread on IHS Markit's iTraxx Europe Crossover index, which measures the cost of insuring against defaults on a basket of underlying sub-investment grade bonds, fell below 229 basis points, the lowest since February 2020, before the COVID-19 financial markets turmoil.
In the cash market, the yield on U.S. high yield bonds closed Friday at a fraction of a basis point above a record low at 4.083%, according to ICE BofA's index.
The rally overturns a sluggish credit performance from most corporate bond markets last month.
Following a strong start to the year, valuations in May had started to look less attractive to investors, who also had to take stock of uncertainty around the inflation outlook and last week's European Central Bank meeting.
Messaging from the ECB and U.S. Federal Reserve has "helped stabilize rates, bring down rates volatility, and ultimately been a strong tailwind for investors to take risk again in credit – benefiting high yield," said Barnaby Martin, head of credit strategy at BofA.
In Europe's cash market, junk yields are at their lowest since 2017, while the spread they pay on top of safer assets is at the lowest since January 2020, according to ICE BofA.
High yield bonds have performed strongly this year, even through a sharp sell-off in government and investment-grade corporate bonds at the end of the first quarter, as investors continue to hunt for yield in a low rate environment. The higher coupon income on junk bonds helps shield investors from sharp price swings, another key supportive factor.
Investment-grade bonds, which are more sensitive to a rise in underlying rates with longer maturities, have also rallied in May, outperforming junk bonds in the U.S., while spreads are at their lowest this year in Europe, according to ICE BofA.
(Reporting by Yoruk Bahceli, editing by Karin Strohecker)