BNP predicts spread grind-down and periodic volatility in 2010

In research published today, BNP Paribas says that the easy money has been made in credit and going forward a slow grind down in spreads coupled with periodic bouts of volatility is on the cards this year. Despite the record amount of supply in 2009, the liquidity premium within credit came down significantly over the year from 275bp to 72bp. The long term average is 62bp, with standard deviation at 58bp and minimum at 13bp.

Performance for investment grade credit in the euro zone was driven by both spread compression and a sharp fall in yields, the former leading to credit outperforming government paper. In the US, yields generally increased, leading to negative returns for treasuries over 2009. Credit was supported by tremendous funds inflows over the year that outweighed the inflows into other asset classes. Given this, says BNP, it is not surprising that credit spreads have rallied fiercely. Although demand technicals waned towards the end of the year, they remain strong for credit.

High yield was the best performer of all major asset classes in 2009, particularly in Europe, with total returns in excess of 76%. Cash outperformed CDS throughout the year, although in December the tightening in Crossover was so rapid that cash lagged behind.

With default rates about to peak and a refinancing risk relatively low in 2010, the main uncertainty going forward is going to be supply, as more loans get refinanced in the high yield market by both existing and new (unrated) bond issuers. That said, demand has been robust in the last few months of 2009, and is expected to remain solid as low investment grade yield continues to drive "unconventional" credit investors' interest towards HY.

With non-financials yields close to the lows of mid-2005, financials still provide extra carry. BNP sees better value in financials where the event risk is primarily a function of ongoing losses, which strategists believe to be manageable over the medium term, especially for European entities. In general, credit should continue to outperform government paper, especially within a low growth, low inflation environment, as the credit default premium more than compensates for the average historical default rate.