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HONG KONG, Sept 17 (Reuters) - Asian bonds rallied on Wednesday on investor relief after the U.S. Federal Reserve's bailout of American International Group eased fears about the global financial crisis.

Benchmark indices snapped back from record spreads on Tuesday in the wake of Lehman Brothers' bankruptcy filing.

Investors had worried that Lehman's collapse and the financial woes of insurance giant American International Group <AIG.N> could broaden and hurt liquidity as risk-aversion would force investors out of Asia .

The iTRAXX Asia ex-Japan high-yield index, a key measure of risk aversion, narrowed by more than 60 basis points (bps) to 670/680 bps. The equivalent investment-grade index <ITAIG5Y=IE> moved in 40 bps to 190/195 bps.

"There is a huge sigh of relief that you are not going to have to deal with another bankruptcy and the implications of unwinding all those CDS trades with AIG on the other side," said Eugene Kim, chief investment officer at Tribridge Investment Partners.

But liquidity was thin as concerns dragged on that the crisis could claim more victims.

The rescue of AIG is the latest event in what has already been one of the most tumultuous weeks in the history of finance and that has changed the face of the U.S. banking sector. Merrill Lynch agreed on Monday to be bought by Bank of America <BAC.N> for $50 billion.

"There is some risk appetite returning in the market but going forward there will be more volatility. You never know what negative headlines will come out next," said trader in Manila.

Spreads on debt from Philippines, one of the most active issuers in the region, contracted but the mood remained jittery. Prices of long-dated bonds rose by around one point.

Bonds due in 2031 were quoted at 109.625/110, while debt due in 2032 traded at 95.875/96.125.

Philippine 5-year credit default swaps (CDS) -- insurance-like contracts that protect against defaults and restructuring -- narrowed to 263/267 bps from the overnight high of 305 bps.

Although the direct impact of the global crisis on Asian balance sheets is expected to be limited, investors are unlikely to resume buying in a hurry.

"Asian credits are in a better position but it will take some time to recover as there is still a lot of leverage out there and banks are not in a position to take the bonds on their books," said Rachana Mehta, head of fixed income at KE Capital Partners.

(Reporting by Umesh Desai; Editing by Ken Wills & Jan Dahinten)

((umesh.desai@thomsonreuters.com; +852 2843 6935; Reuters

Messaging: umesh.desai.reuters.com@reuters.net; ))

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