Western Asset-Liquidity in the Credit Markets, March 2012

8/2/2019 Western Asset-Liquidity in the Credit Markets, March 2012

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Biographies

Michael C. Buchanan, CFAHead of Credit

Liquidity in the Credit MarketsMarch 1, 2012


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Liquidity in the Credit Markets

Liquidi ty has declined across the fixed-income markets

This is a function of:

Increased regulation

Assets being concentrated in fewer institutions

Changes in risk-taking behavior

Reduced liquidi ty has material implications for investors


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Liquidity and Volatility in Credit


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$235

$56

$45

0

50

100

150

200

250

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

PrimaryDealerNetHoldings(USD,b

illions)

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

GrossS

izeoftheUSCreditMarke

t(USD,trillions)

Source: Federal Reserve Bank of New York, Barclays Capital. As of 08 Feb 12

Credit market = Barclays Capital U.S. Investment-Grade Credit Index + Barclays Capital U.S. High-Yield Index

Holdings (left)

Credit Market (right)

US Primary Dealer Net Holdings of Corporate Bonds Greater Than 1 Year

Wall Street not taking any risk at the moment


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60-Day Moving Average Daily Corporate Bonds Trading Volume

0

500

1000

1500

2000

2500

3000

3500

4000

4500

Oct 05 Apr 06 Oct 06 Apr 07 Oct 07 Apr 08 Oct 08 Apr 09 Oct 09 Apr 10 Oct 10 Apr 11 Oct 11

USD(millions)

High-Yield Investment-Grade

Source: Bloomberg. As of 27 Feb 12

Daily Corporate Trading Volume

Less position-taking by dealers has resulted inconsistently lower trading volumes


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Propor tion o f Total Trading: Top 20% of Bonds (4-Week Average)

80

82

84

86

88

90

92

94

Sep

09

Nov

09

Jan

10

Mar

10

May

10

Jul

10

Sep

10

Nov

10

Jan

11

Mar

11

May

11

Jul

11

Sep

11

Percent

Source: TRACE, JPMorgan. As of 17 Oct 11

The Portion of Trades of On-the-Run Bonds Has Increased

Most active position-taking occurring in on-the-run names


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Depth of Trading

4% of tickers responsible for 50% of all trading volume

Cumulative Percent of 2011 High-Yield Volume by Ticker

0%

20%

40%

60%

80%

100%

0 200 400 600 800 1000 1200

>

Percent

Source: Market Axess, Barclays Capital. As of 31 Dec 11

Bucket Tickers

Fraction of TotalVolume # of Bonds

Debt Amoun t(USD, billions)

Low Liquidity 821 10% 1 $0.3

Average Liquidity 273 40% 2 $1.1

High Liquidity 46 50% 7 $6.0

Source: MarketAxess, Barclays Capital. As of 31 Dec 11

Average per Ticker

Breakdown of US High-Yield Issuers


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Smaller Issuers Trading Less Frequently

High-Yield Cash: % of Daily Volume in Small Issues (


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125

145

165

185

205

225

245

265

Feb 10 May 10 Aug 10 Nov 10 Feb 11 May 11 Aug 11 Nov 11

CitigroupBroadIn

vestmentGradeCorporate

IndexOAS(bps)

0

5

10

15

20

25

30

35

40

45

ModeledBid-OfferSpread(bps)

Citigroup Broad Investment Grade Corporate Index OAS (left) Modeled Bid-Offer Spread (right)

Source: Citigroup. As of 17 Nov 11

Transaction Costs Substantially Higher in Last Six Months

Bid/ask spreads have widened as aresult of lower trading volume


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Volatility has subsided since credit crisis, butremains elevated compared with pre-crisis levels

Less Liquidity/Higher Volatility

Standard Deviation of Monthly Excess Returnsof Barc lays Capital U.S. Credit Index

70

221

0

50100

150

200

250

300

19972007 20082011

StandardDeviation(bps)

Source: Barclays Capital. As of 31 Dec 11

+316%

VIX Index Levels

0

10

20

30

40

50

6070

2004 2005 2006 2007 2008 2009 2010 2011 2012

Risk has declined

but will it bridge

the gap?

Volatility artificially low

during this period

Source: Bloomberg, Western Asset. As of 31 Jan 12


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0.0x

0.2x

0.4x

0.6x

0.8x

1.0x

1.2x

1.4x

Mar 06 Sep 06 Mar 07 Sep 07 Mar 08 Sep 08 Mar 09 Sep 09 Mar 10 Sep 10 Mar 11 Sep 11

StandardDe

viationofFlowvs.

CashProduction(x)

Source: Lipper, Barclays Capital. As of 31 Oct 11

Standard Deviation of High-Yield Fund Flows

As market has become less liquid, retailcash flows have become more volatile


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Causes of Lower Liquidity and Higher Volatility


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New Regulations Require Banks to Take Less Risks

Banks are reducing risk by lowering the amount of r isk-weighted assets

Domestic regulation

Dodd-Frank

Volcker Rule

Fed stress tests

Global regulation

Basel III

EBA stress tests

Rating agencies

New rating methodologiesDowngrading sovereigns

Downgrading financials


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Key Financial Market ChangesBack to Basics

Banks Capital Ratios Improving

6.5TCE/TA

12.4Tier 1

9.9

Tier 1 Common

3

6

9

12

15

1Q92 4Q94 3Q97 2Q00 1Q03 4Q05 3Q08 2Q11

Percent

Source: Federal Reserve, Company Filings, SNL Financial, Goldman Sachs Research.

As of 30 Jun 11

Total Commercial and Industrial Loans Outstanding

Month-over-MonthChange (right)

1.1

1.21.3

1.4

1.5

1.6

1.7

2007 2008 2009 2010 2011

USD(trillions)

-0.06

-0.04-0.02

0.00

0.02

0.04

0.06

USD(trillions)

Commercial and Industrial

Loans Outstanding (left)

Source: Federal Reserve. As of 31 Aug 11

Loan/Deposit Ratio

80

85

90

95

100

105110

Jan

08

May

08

Sep

08

Jan

09

May

09

Sep

09

Jan

10

May

10

Sep

10

Jan

11

May

11

Percent

100-102% Loans / Deposits

81-90% Loans / Deposits


Cash + Treasuries/Assets

12

16

20

24

28

3236

Jan

08

May

08

Sep

08

Jan

09

May

09

Sep

09

Jan

10

May

10

Sep

10

Jan

11

May

11

Percent 12-19% of Assets

20-29% of Assets



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Concentration/Insti tutionalization of Hedge Funds

8

9

10

11

12

13

14

15

2004 2005 2006 2007 2008 2009 2010 2011

Percent

-

50

100

150

200

250

300

USD(billions)

% of Total AUM in Top 10 Funds (left) AUM of Top 10 Hedge Funds (right)

Source: Barclays Capital, Morningstar. As of 31 Dec 11


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Risk-Taking Behavior Damaged Since Credit Crisis

Tail risk analysis much more topical as a result of 2008 and current macro concerns

Importance of risk management as interactive component of investment process

Lower tolerance for government-funded bailouts

Credit Inventory as Percent of Market Size

0

2

4

6

8

10

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Percent

Source: Federal Reserve Bank of New York, Barclays Capital. As of 08 Feb 12

Credit market = Barclays Capital U.S. Investment-Grade Credit Index + Barclays Capital U.S. High-Yield Index


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Managing Credit Portfol ios in a Less Liquid/Higher Volatility Environment


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Portfolio Diversification ConceptsMore Liquid Alternatives

Synthetic credit indices

Swaps and options on CDX indices

Equity indicesOptions on S&P 500

Currencies

Forwards, options

Duration management

US Treasury futures and options

Interest rate swaps


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IDX Bid Spreads

350450

550

650

750

850

950

Dec

10

Jan

11

Feb

11

Mar

11

Apr

11

May

11

Jun

11

Jul

11

Aug

11

Sep

11

Oct

11

Nov

11

Dec

11

Jan

12

Spread(bps)

FORENE 9.625 08/15/2017 ACI 8.75 08/01/2016

Source: Barclays Capital. As of 06 Feb 12

Demand Higher Concessions for Less Liquidity

38 millionFORENE

500+ millionACITrading Volume Since Issuance (USD)

31 Dec 10:133 bps

06 Feb 12:317 bps

Spread Between 144a and Registered High -Yield Bonds

-200

-100

0

100

200

300

400

2005 2006 2007 2008 2009 2010 2011

Spread(bps)

Source: Barclays Capital. As of 04 Nov 11


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As Cost of Trading Increases, Fundamental Research Becomes More Important

Credit investors wi ll see less of their return coming from active trading due toprohibitive transaction costs

Strong fundamental credit research is increasingly important to successfulinvestment strategies

Current credit market with generous liquidi ty premiums ideal for fundamental,value-based investing


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Conclusion

Liquidity is down, volatility is up

We expect this condition to persist because some portion is driven by new

regulations

Value can be extracted by investing in less liquid bonds

Diversif ication of portfol io risk may require strategies and instruments that have

not been used histor ically

Increasing importance of fundamental research


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Questions & Answers

21

Thank you.


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Risk Disclosure

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Western Asset-Liquidity in the Credit Markets, March 2012

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