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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
Source: Federal Reserve. As of 31 Aug 11
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
Source: Federal Reserve. As of 31 Aug 11
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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
Western Asset Management Company 2012. This publication is the property of Western Asset Management Company and is intended for the sole use of itsclients, consultants, and other intended recipients. It should not be forwarded to any other person. Contents herein should be treated as confidential andproprietary information. This material may not be reproduced or used in any form or medium without express written permission.
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