Credit markets should see lower volatility in 2009: Merrill

(Reuters) - Credit markets should see lower volatility and a lot less stress next year than was the case for much of 2008 as market turmoil changes from a financial crisis to an economic one, Merrill Lynch said.

"The risk backdrop is likely to evolve from one of an acute financial crisis into one of a more tangible, albeit possibly severe, economic downturn," the brokerage wrote in a research note dated December 3.

Financial sector risk along the lines of 2008 is likely to slowly fade as governments have shown their ability to support ailing banks, Merrill said.

"While a downturn in growth may nonetheless be painful, we think this should be easier for credit investors to navigate."

Merrill said it expects investment-grade bonds to be somewhat of a 'sweet spot' next year, given unprecedented valuations and less compelling returns in other asset classes.

However, sector returns will increasingly be driven by factors such as government support and refinancing ability, the brokerage wrote.

Merrill said it was overweight on defensive corporate sectors with earnings visibility like telecoms, utilities and tobacco.

"Cash flow in these sectors is relatively strong, bond market financing is available and issuers have the flexibility to cut shareholder payouts to bolster liquidity," the brokerage said.

It cut chemicals sector to 70 percent "underweight" from 30 percent "underweight," citing reduced sentiment in the sector after a profit warning from German chemicals giant BASF.

Merrill also downgraded European retail and building materials sectors to 70 percent "underweight" from 30 percent "underweight" on weak end demand.

(Reporting by Amiteshwar Singh in Bangalore; Editing by Himani Sarkar)