You probably heard that Libor rates in Europe were down on Monday and that other measures of interbank lending were improving. That was one reason traders had their smiley faces on.

However, there are a couple of cracks in the story. For one thing, spreads on the new Markit iTraxx Crossover index, which tracks the cost of insuring subprime corporate debt against default, widened by a record amount. It was quoted at 778 basis points this week, after trading at 770 on Friday.

The reason for that widening spread is that debt market participants still believe that the credit crunch will claim more victims—either bond issuers, bond holders, or both. A credit strategist at German bank Dresdner Kleinwort told Dow Jones Newswires that despite recent government actions to shore up the global banking system, conditions in money markets remained difficult.

Our own ace credit analyst Brian Reynolds agrees, stating that his work suggests credit bears are not unhappy to see Libor rates fall while the real credit markets stagger because it lures the public into complacency. He thinks that bears will strike once again after the election with even greater force, much like they did in November last year after the S&P 500 Index hit an all-time.

Indeed, Reynolds believes that credit markets are worse than ever. He says it’s amazing that 18% yields on junk bonds still can’t produce buyers, and that instead he’s still seeing forced selling.

On Oct. 16, he said, junk spreads—the difference in interest that must be paid in junk bonds vs. Treasuries—blew past the record set a week before by hitting 1,572 basis points, eclipsing the prior highest level of 1,536.

When it comes to why this is happening, he mentioned that the same things are happening in credit as we’re seeing in stocks. Last week, he noted a hedge fund manager with $30 billion in assets was shutting down its $1.5 billion credit funds. He said he didn’t know how much leverage the fund used, but we know that leverage of 10, 20, or 30 times is not uncommon in credit. If 10 times, the fund controlled $15 billion in assets. If 20 times, the number is $30 billion. All of that must be sold into the hole. "Remember, there are many funds like this," he says.

Reynolds said the fund’s prime broker seized $642 million of leveraged loans pledged as collateral and was auctioning them off. He wished the prime broker luck in getting bids in this market for the collateral, because "when the Street knows that you need to sell, it is like a shark smelling blood in the water. If you need to sell, the credit bears will make you cry."

What’s worse, he noted: Forced sales of collateral force all the players in the world to make new marks for their assets, revaluing them downward. The market does not care what the SEC does to accounting rules; in the world of collateral, lenders try to price things at market levels in order to get their money back. He says the collateral seizures ensure the prime brokers get most of their capital returned, but they are like chum—bait usually consisting of oily fish ground up and scattered on the water—to the shark-like credit bears.

Reynolds observes that this fund follows a disturbing pattern: they announce that they are shutting down, and that they intend to sell some assets in coming months to do that. From a market perspective, he says, it would be better if they sold, then announced the closure. In this instance, the fund intends to sell 20% of their assets in the next six months, then sell the rest over the next three years. "They just gave their game plan to the bears, and told them that they’ll be chumming 20% of their assets for the next 6 months," Reynolds said. "Good luck to them getting bids."

Reynolds notes that stocks have been bouncing around lately in a way that shows equity investors want the bear market to be over. But the credit market continues to point to either a new round of bankruptcies, bondholders getting in trouble, or both. He believes that if stocks were priced like credit, then the S&P 500 would be under the 800 level, or at least 15% lower than where it is today.

Reynolds is not a perma-bear; he’s just someone who has been around the block a few times in both the equity, credit and money market ends of the business, and understands how they interact. His views reinforce my view that caution is still warranted, so please do take heed.

One bond position that I do like, however, is the iShares Lehman MBS Fixed Rate Bond Fund (MBB), which yields 4.65%. It mostly holds the better mortgages, and its being buoyed by buying from PIMCO. The fixed income fund company, run by Bill Gross, has been a massive buyer of high-quality mortgage backed securities lately, according to a Dow Jones Newswires story this week. The report said Pimco’s flagship Total Return Fund raised its holding of mortgaged back securities to 79% of its entire portfolio by the end of September, a level not seen since June 200. It was up from 69% a month earlier. Pimco was snubbing U.S. government debt.

The article reported that Pimco bond manger Steve Rodosky said he continues to favor agency MBS—the mortgage pass-through securities that are sold and guaranteed by government-sponsored enterprises Fannie Mae and Freddie Mac which were nationalized by the U.S. government last month—as well as agency debt. The explicit stamp from the federal government reduces credit risk, making the debt more attractive to investors.

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This article was written by Jon Markman, contributor to InvestorPlace Media. For more actionable insights likes this, visit www.InvestorPlace.com.