UPDATE 2-JP Morgan's notes weaken as bond rally fizzles

(Adds background, updates bond spreads)

NEW YORK, May 14 (Reuters) - A $2.5 billion issue of notes sold by JP Morgan Chase & Co JPM.N on Wednesday weakened in secondary trading on Thursday in the latest sign that a corporate bond rally is starting to sputter.

Yield spreads on the five-year notes widened by about 7 basis points to 282 basis points more than Treasuries, according to MarketAxess. They had traded as wide as 295 basis points over Treasuries earlier in the session.

The JP Morgan deal is the latest of several corporate bond sales to trade poorly in recent weeks after a glut of supply gave the market a heavy tone.

Investors have turned more cautious on corporate bonds after a massive tightening in yield spreads left less upside in the market, especially as weak economic data signals that no quick end to the recession is in sight.

“I just think the tone out there has drastically changed and for the most part people are a little jumpy,” said Richard Lee, head of fixed income at New York broker-dealer Wall Street Access. “There’s still a lot of supply in the pipeline. As issues trade poorly, the buyside gets jumpy and they demand a much bigger discount to get into the next deal.”

Whereas companies a few weeks ago were able to sell new bonds with just a 10 to 15 basis-point yield premium over outstanding issues, that will likely grow to 50 to 60 basis points or more as new issues trade poorly, he said.

Investors began to feel cautious about a six-week rally in corporate bonds after a bond sale by Dow Chemical DOW.N last week turned in a poor performance.

Spreads on Dow’s new 10-year notes have widened by 69 basis points from where they were issued to 594 basis points over Treasuries, while its five-year notes have widened 58 basis points to 608 basis points, according to MarketAxess.

The longer-dated portions of a three-part bond sale by Microsoft Corp MSFT.O have also traded poorly. Spreads on a 30-year bond have widened by 12 basis points to 117 basis points, while 10-year notes have widened by 2 basis points to 107 basis points, according to MarketAxess.

Technology companies in general are weakening in the corporate bond market amid worries that customers will cut orders as the recession drags on.

Spreads on IBM's IBM.N 7.625 percent notes due in 2018 have widened to 229 basis points after starting the week at 185 basis points, according to MarketAxess.

“I like corporate spreads in general but I do think we’re going to have a very, very choppy market for a while,” said Lee of Wall Street Access. (Reporting by Dena Aubin; Editing by James Dalgleish)