Spreads in credit markets are so wide they have priced in any default rates that history can present, argues Deutsche Bank, which means buy-and-hold investors now face an unprecedented opportunity to gain, if they are willing to ride out the current volatility.

The bank looked at as many five-year periods of corporate defaults it could find data for (mostly in the United States). Current spreads imply a default rate for bonds in developed countries rated single-A or double-A to reach 17%-20%. But the worst five-year period for similarly rated bonds has never exceeded a default rate of 2.5%. Even assuming that the current crisis is far deeper than what has been previously experienced, bond investors today would be more than compensated for the potential default risk they assume, says Deutsche.

ôAlthough the impact of unwinding these trades could get worse before it gets better,ö says Jim Reid, credit strategist, ôbuy-and-hold investment-grade bond investors may have a once-in-a-cycle opportunity to exploit the stress in the structured credit market.ö

The catch, of course, is that most investors, including those money managers who make up most of the credit buy-side, are subject to marks to market. With investment-grade credit spreads deteriorating by 20bp-30bp in the space of a month, a decline that is sharpening this week as the market digests news of the collapse of Bear Stearns, such volatility is crippling. The credit market has virtually closed down, with investors either too scared to go back in, or struggling to source liquidity to deal with margin calls.

ôIt does seem like a one-way trade right now,ö says a credit analyst at Deutsche, ôwith investors selling bonds and buying protection.ö

So that means the traditional credit investors are unlikely to be the ones who put the bid back in the market. Where to find such a buyer? Institutional investors such as pension funds and insurance companies could be candidates, if they can file these bonds as æhold to maturityÆ and therefore can ignore the volatility. For an investor more interested in long-term asset/liability matching, credit now looks compelling.

Buyers could also come on the back of restructuring capital in portfolios. For example, in high yield, the average spread now is 900bp over already high yields of 12%-14%. An equity investor in the same companyÆs stock might look at her risk, which will look about the same if not worse than the default risk. Money managers may find revamping the portfolio to sell stock and buy bonds a rewarding bet.

Similarly, the crossover spread between secured and unsecured leverage loans has risen, meaning investors in this (practically frozen) market may find secured leveraged loans attractive, if they can stomach short-term losses.

Finally, governments could provide the bid for credit. In the wake of Northern RockÆs nationalisation and now the Federal Reserve-engineered buyout of the wreckage of Bear Stearns by JPMorgan, this is no longer a wild notion. What if the US Treasury, in a bid to keep the credit market from utter collapse, issues sovereign bonds to finance the purchase of corporate bonds? As an actor that can ignore short-term prices, the US government as lender of last resort could actually stand to make quite a profit. (Never mind what such an act would imply for the rest of us.)

Horror scenarios aside, DeutscheÆs point about the turmoil in credit markets is that it stems from unwinding leveraged bets û not because the fundamentals of these companies suggests many will default. There were virtually no defaults in 2007, and recovery rates improved. This is one reason why spreads to compensate for defaults have narrowed, from 468bps for single-Bs in 2006 to 349bps in early 2008.

Yet deleveraging has driven default-spread premiums to near-record levels, with the greatest dislocation in single-A names. Deutsche argues few of these investment-grade bonds will default, representing a great opportunity for buy-and-hold investors. This particularly holds true for international Asian bonds, which are mainly denominated in US dollars, and which enjoy terrific country and company fundamentals.

ôWe project few if any defaults in 2008, versus rating agency estimates of 4.5%-4.8%,ö says Todd Schubert, director of credit research. ôWe are positive on a number of Asian high-yield names.ö

The caveat is that right now the credit markets are not functioning. The bulk of the buy-side is unwilling or unable to take the plunge. Greed will not replace fear until there is more certainty about the true extent of subprime mortgage-related write-offs, the fate of the US finance sector and the resiliency of the US dollar. Which means this fine, once-in-a-decade opportunity is likely to be missed by just about all of you.