Biographies

Liquidity in the Credit Markets

March 1, 2012

Michael C. Buchanan, CFA

Head of Credit
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Liquidity in the Credit Markets

Liquidity 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 liquidity has material implications for investors

Liquidity and Volatility in Credit

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

250 Holdings (left) Primary Dealer Net Holdings (USD, billions) 200

$235

5.5 5.0 4.5 4.0 3.5

Gross Size of the US Credit Market(USD, trillions)

150

100

Credit Market (right)

3.0 2.5 $45 2.0 1.5

50

$56

0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
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

Wall Street not taking any risk at the moment

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Daily Corporate Trading Volume

60-Day Moving Average Daily Corporate Bonds Trading Volume 4500 4000 3500 3000 USD (millions) 2500 2000 1500 1000 500 0 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
Source: Bloomberg. As of 27 Feb 12

High-Yield

Investment-Grade

Less position-taking by dealers has resulted in consistently lower trading volumes

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

Proportion of Total Trading: Top 20% of Bonds (4-Week Average) 94

92

90

Percent

88

86

84

82

80 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

Source: TRACE, JPMorgan. As of 17 Oct 11

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

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Depth of Trading
Cumulative Percent of 2011 High-Yield Volume by Ticker

100% 80% Percent 60% 40% 20% 0% 0 200

400

600

800

1000

1200

<< Most Liquid -- Tickers -- Least Liquid >>

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

Breakdown of US High-Yield Issuers Average per Ticker Bucket Low Liquidity Average Liquidity High Liquidity Tickers 821 273 46 Fraction of Total Volume 10% 40% 50% # of Bonds 1 2 7 Debt Amount (USD, billions) $0.3 $1.1 $6.0

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

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

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Smaller Issuers Trading Less Frequently

High-Yield Cash: % of Daily Volume in Small Issues (<$400mm) 35 33 31 29 27 Percent 25 23 21 19 17 15 Jan 10 Apr 10 Jul 10 Oct 10 Jan 11 Apr 11 Jul 11 Oct 11 Jan 12
Source: CSFB. As of 15 Feb 12

Issue sizes of $400 million or less represent 55% of issues in the high-yield market
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Transaction Costs Substantially Higher in Last Six Months

Citigroup Broad Investment Grade Corporate Index OAS (left) 265 Citigroup Broad Investment Grade Corporate Index OAS (bps) Modeled Bid-Offer Spread (right) 45 40 35 225 30 205 25 20 15 165 10 145 5 0 May 10 Aug 10 Nov 10 Feb 11 May 11 Aug 11 Nov 11
Source: Citigroup. As of 17 Nov 11

245

Modeled Bid-Offer Spread (bps)

185

125 Feb 10

Bid/ask spreads have widened as a result of lower trading volume

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Less Liquidity/Higher Volatility

Standard Deviation of Monthly Excess Returns of Barclays Capital U.S. Credit Index Standard Deviation (bps) 300 250 200 150 100 50 0 19972007
Source: Barclays Capital. As of 31 Dec 11

221 +316% 70

20082011

70 60 50 40 30 20 10 0 2004 2005 2006 2007 Volatility artificially low during this period

VIX Index Levels

Risk has declined but will it bridge the gap? 2008 2009 2010 2011 2012

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

Volatility has subsided since credit crisis, but remains elevated compared with pre-crisis levels
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Standard Deviation of High-Yield Fund Flows

1.4x Standard Deviation of Flow vs. Cash Production (x)

1.2x

1.0x

0.8x

0.6x

0.4x

0.2x

0.0x Mar 06 Sep 06 Mar 07 Sep 07 Mar 08 Sep 08 Mar 09 Sep 09 Mar 10 Sep 10 Mar 11 Sep 11
Source: Lipper, Barclays Capital. As of 31 Oct 11

As market has become less liquid, retail cash 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 risk-weighted assets Domestic regulation
Dodd-Frank Volcker Rule Fed stress tests

Global regulation
Basel III EBA stress tests

Rating agencies
New rating methodologies Downgrading sovereigns Downgrading financials

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Key Financial Market Changes

Back to Basics
15 12 Percent 9 6 TCE/TA 3 1Q92 4Q94 3Q97 2Q00 1Q03 4Q05 3Q08 2Q11
Source: Federal Reserve, Company Filings, SNL Financial, Goldman Sachs Research. As of 30 Jun 11

Banks Capital Ratios Improving 1.7 Tier 1 Tier 1 Common 6.5 USD (trillions) 12.4 9.9 1.6 1.5 1.4 1.3 1.2 1.1 2007

Total Commercial and Industrial Loans Outstanding 0.06

Commercial and Industrial Loans Outstanding (left)

0.04 0.02 0.00 -0.02 -0.04 -0.06 USD (trillions)

Month-over-Month Change (right)

2008

2009

2010

2011

Source: Federal Reserve. As of 31 Aug 11

Loan/Deposit Ratio 36 32 81-90% Loans / Deposits Percent 28 24 20 16 12

Cash + Treasuries/Assets 20-29% of Assets 12-19% of Assets

110 105 Percent 100 95 90 85 80

100-102% Loans / Deposits

Jan May Sep Jan May Sep Jan May Sep Jan May 08 08 08 09 09 09 10 10 10 11 11
Source: Federal Reserve. As of 31 Aug 11

Jan May Sep Jan May Sep Jan May Sep Jan May 08 08 08 09 09 09 10 10 10 11 11
Source: Federal Reserve. As of 31 Aug 11

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Concentration/Institutionalization of Hedge Funds

% of Total AUM in Top 10 Funds (left) 15 AUM of Top 10 Hedge Funds (right) 300

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250

13 200 Percent 12 150 11 100 10 50 USD (billions)

8 2004 2005 2006 2007 2008 2009 2010 2011

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
10 8 6 4 2 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Credit Inventory as Percent of Market Size

Percent
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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

Managing Credit Portfolios in a Less Liquid/Higher Volatility Environment

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Portfolio Diversification Concepts

More Liquid Alternatives

Synthetic credit indices

Swaps and options on CDX indices

Equity indices
Options on S&P 500

Currencies
Forwards, options

Duration management
US Treasury futures and options Interest rate swaps

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Demand Higher Concessions for Less Liquidity

Spread Between 144a and Registered High-Yield Bonds 400 300 Spread (bps) 200 100 0 -100 -200 2005 2006 2007 2008 2009 2010 2011
Source: Barclays Capital. As of 04 Nov 11

IDX Bid Spreads 950 850 Spread (bps) 750 650 550 450 350 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
31 Dec 10: 133 bps

FORENE 9.625 08/15/2017 Trading Volume Since Issuance (USD) ACI 500+ million FORENE 38 million

ACI 8.75 08/01/2016

06 Feb 12: 317 bps

Source: Barclays Capital. As of 06 Feb 12

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As Cost of Trading Increases, Fundamental Research Becomes More Important

Credit investors will see less of their return coming from active trading due to prohibitive transaction costs Strong fundamental credit research is increasingly important to successful investment strategies Current credit market with generous liquidity 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 Diversification of portfolio risk may require strategies and instruments that have not been used historically Increasing importance of fundamental research

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Questions & Answers

Thank you.

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Risk Disclosure

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