High-grade credit is likely to outperform equities as pressure intensifies on governments to prop up troubled companies, a move which would increase the odds for the sort of stagnation seen in Japan in the past decade.

Any plan to keep bad companies alive, just as in Japan's lost decade, would make the environment more difficult for healthy companies and erode profitability, weakening their ability to pay dividends and the appeal of their shares to investors, analysts said.

Governments are under pressure to take drastic action to save jobs in the face of a global financial crisis.

Under this scenario (of saving bad companies) credit is a wonderful asset class but equities could gradually go lower and lower as the market realizes what it means for longer-term profitability, said Jim Reid, credit strategist at Deutsche Bank in a note.

Japan suffered long-running economic stagnation and a weak banking system, after a real estate bubble burst, as politicians sought to keep so-called zombie companies afloat to preserve jobs and banks were loathe to unveil the extent of their bad loans.

It's quite plausible that zombie companies will emerge as in Japan. One only has to look at auto companies as an example, said Philip Lawlor, chief portfolio strategist at Nomura. Under this scenario credit should outperform equities.

Automakers worldwide have taken a beating on the back of what is expected to be the worst year for major industrial economies since the end of the World War Two.

With car loans largely drying up and fear spreading among financially overstretched consumers, U.S. auto sales fell by 37 percent in January -- their slowest pace since 1982.

General Motors and small rival Chrysler have requested nearly $22 billion in additional U.S. government loans.

In Europe, France pledged earlier this month to lend 6 billion euros ($7.8 billion) to Renault and PSA Peugeot-Citroen over five years in return for a pledge not to close sites in France during the duration of the loan.

Renault five-year credit default swaps (CDS) were quoted at about 402 basis points, down from their peak of 555 basis points on Dec 5, 2008, while Peugeot five-year CDS were traded at around 390 basis points versus 524 basis points hit on the same December day.

On the other hand, their stocks were not too far off their multi-year lows hit in either December or January.

CENTRAL BANK SUPPORT

Sylvie Golay, a credit strategist at Credit Suisse, said any move by central banks to buy corporate debt would also support the credit markets, boosting their performance against equities.

The Bank of England launched a scheme on Friday to buy short-term corporate debt, the first stage of a British drive to breathe life into moribund credit markets and stave off the worst effects of recession.

If we would come to such action from the central banks and the governments, then you would have the outperformance in credit, Golay said. She added that senior bank debt had been performing well, boosted by issues guaranteed by governments.

European credit spreads, measured by the investment-grade Markit iTraxx Europe index, narrowed to around 170 basis points from its peak of around 220 basis points on December 5 -- after pricing in more bad news than equities.

Non-financial investment-grade companies sold more than 60 billion euros worth of bonds in January through mid-February.

The pan-European FTSEurofirst 300 share index, by contrast, was slightly higher than its low set in January.

Another credit analyst said if companies started to struggle, they would cut or forego dividends.

You can't make those decisions on credit, you can't choose not to pay coupons, he said. The dynamics of corporate bonds or fixed income bonds generally relative to equities are benefited in this environment, where there are question marks whether you can get returns on equities at the moment.

(Editing by Hans Peters)

Japan Credit Suisse