Default and Liquidity Premia in

Credit Markets
Sam DeRosa-Farag
June 2016

Outline and Conclusions

Why Liquidity Premia Increased

Turnover rates declined significantly following 2008.

Liquidity has been repriced across IG, HY, Leveraged loans and EM.
Less liquid issues have seen a disproportionate increase in liquidity premia
Liquidity premia and default rates are not correlated, even though one
might assume so.
Default rates are not a systemic function of GDP. Defaults are highly
clustered within industries and are a function of industry overcapacity and
obsolescence.
Liquidity premia compensate for the ability to sell over a shorter time
horizon. If assets are held beyond a short time horizon we should be able
to get paid for liquidity risk in the final total return. The divergence
between coupon and total return represents this premia.
2

Increasing Liquidity Premia vs. Declining

Default Rates
The decline of liquidity
Higher turnover rates and a decline in dealer capital as a percentage of
the market resulted in higher liquidity premia.
On average, turnover rates declined 30-50% (pre vs. post-2008) for
mortgages, IG and HY. Treasuries experienced a decline in turnover of
70%.
On average, liquidity premia for credit doubled over the period 1990
to post-2008. This increase was 2x for HY and 1.5x for Leveraged
Loans.
The premia applied to smaller issues was up 2.5x (pre to post-2008
spread levels).
Default rates declined while liquidity premia increased; a decreasing
proportion of HY and leveraged loan returns can be explained as
compensating for default loss risk.
3

Measuring Liquidity Premia: Methodology

Methodology
Liquidity premia is calculated by subtracting the spread at the
beginning of the period minus the default loss rate realized at the end
of the period. The balance is estimated to be the liquidity premia.
Liquidity premia is what you keep net of defaults in total return.
IMF methodology: breakdown the credit spread into default risk,
systemic risk and liquidity risk (Market Liquidity: Resilient Or
Fleeting? IMF, Oct 2015).

HY and Leverage Loans:

Returns vs. Initial Coupon and Average Default Loss Rates
for the period 1997-2013, from peak to peak
1

Annualized Return
1997-2013

Beginning Coupon
1997

Avg Default Loss

Rate 1997-2013

Starting Coupon
- Default Loss Rate

Difference
Column 4 vs 1

LL

5.20%

8.05%

1.25%

6.80%

1.60%

HY

7.54%

10.47%

2.68%

7.79%

0.24%

Initial coupon net of default loss rate has been a reasonable estimate of
expected return over the past two full economic cycles.
The differences (column 5) are due to frictions i.e. calls, tenders, redemptions,
refinancing and upgrades / downgrades. For leveraged loans, the rapid decline
in rates after 2008 prior to the implementation of LIBOR floors resulted in a
larger difference.

Based on CS HY and Leveraged Loan Indices and CS default data for HY and Leveraged Loans
Source: Credit Suisse

Size of the US HY Market has Grown

85% Since 2008

Source: BofA Merrill Lynch Global Research

Size of the US IG Market more than

Doubled Since 2008

Source: BofA Merrill Lynch Global Research

Corporate Bonds Primary Dealer Inventory

While primary dealer inventory of corporate bonds has plummeted, the
outstanding stock has risen sharply

Source: FRB, Haver Analytics, Deutsche Bank

Liquidity in the Financial markets

The decline in liquidity 2015 vs. 2006, market turnover, defined as the % of
the total market which trades in a year:
HY turnover declined 30%, 70% of the market now trades per year.
IG turnover declined 50%, 45% of the market now trades per year.
While Treasury turnover declined by 70%, 400% of the market still
turns over per year (10x more liquid than IG).
Loan market liquidity was flat between the periods, 60% of the market
trades per year.
The size of the CLO market is now $357bn, with a 35% turnover rate.
CLO liquidity has improved dramatically since 2006.
Equity market liquidity was flat between the periods, 60% of the
market trades per year.
Market composition: The top 20-30 accounts, which were previously
45%-50% of the market, are now 22%-25% of the market. Dealer balance
sheets have declined.
Derivatives volume down 40%-50% in terms of notional value for IG and
HY.
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Change in Liquidity and Average

Market Turnover Rates
Asset Class

Turnover Decline in Liquidity

Treasury

10.0

-70%

HY

0.7

-30%

Lev Loans

0.6

0%

Equity Markets

0.6

0%

CLO

0.4

50%

Source: LSTA, Goldman Sachs Research

10

HY and IG Trading Volume,

% of Market Size

Source: Deutsche Bank, TRACE

11

US Treasury Trading Volume,

% of Market Size

Source: Deutsche Bank, Federal Reserve

12

US Equity Trading Volumes

Source: Deutsche Bank, Bloomberg

13

Change in Market Size and Turnover

by Asset Class, 2006-2014

Source: SIFMA, FINRA TRACE, Goldman Sachs Global Investment Research

14

Fixed Income Trading Assets

for Top US Banks, $bn

*Avg. of first three quarters.

Source: Regulatory filings, Goldman Sachs Global Investment Research.

15

US HY Spread:
Large vs. Small Issuers
500

Small vs Large Issuer Spread, bps

400
300
200
100
0
-100
-200
2006

2007

2008

2009

Smallest vs Largest Issuers Spread

2010

2011

2012

Pre-recession Avg

2013

2014

2015

Post-recession Avg

Source: BofA Merrill Lynch Global Research

16

Leveraged Loan Liquidity Premium

Implied Liquidity
Premium (bp)

400
300

Average 1995-99: 202 bp

226

200
100

197

228 215

Average 2010-15: 302 bp

Average
344
328 335
Average 2003-08: 243 bp
324
1995-2015:
195 bp
269
267
255
234 243 255
226
191

142
55
0

0
-6

(100)
(200)
(300)

-237

Source: Credit Suisse (Leveraged Loan Index and Default Review)

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US HY Illiquidity Premium
1384
1300
1100
900
1982-1989 92 b.p.

1998-2007 310 b.p.

1992-1997 234 b.p.

2010-2014 341 b.p.

700
498

500
300
100

223
101

352347
245227
238
188
144 135

219
69

58 43

16

496
458
364340

178

130

486
417

75

351

327 308
231

140

-100

-240
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002*
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014

-300

Source: Credit Suisse

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US High Yield Liquidity Premium

High yield liquidity premium: excess spread over credit losses
Excess Spread over Next-12-month Defaults, bps

1,200

1,000
800
600
400
200
0
-200
-400
1986

1989

1992

1995

1998

Excess Spread over Credit Losses

2001

2004

2007

2010

2013

Poly. (Excess Spread over Credit Losses)

Source: BofA Merrill Lynch Global Research

19

Excess HY Spread Over Credit Losses

Average spread moving higher due to rising liquidity premia

Source: Deutsche Bank

20

Low Liquidity Premium in EM

Breakdown of Global EM High Yield
Spread into Compensation for Default
Risk and Liquidity Premium

EM Liquidity Premium (Spread in Excess

of Forecast Default Losses) Is Currently
Relatively Low

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Dynamics of a default cycle

Historically, higher market default loss rates have been driven by losses in
specific sectors. Three sectors typically contribute the majority of defaults
during stress periods.
Top 3 sectors by contribution to the market default loss rate:
1989-90: Retail, Gaming & Consumer constituted 73% of defaults
2001-03: Utility, Metals & Aerospace constituted 55% of defaults
2008-09: Transportation, Gaming & Forest Products constituted 54% of
defaults
Historic stress events suggest that the within-sector default rate of the
sector with the highest default rate typically reaches 50-60%:
1989-90: Financials experienced 60% defaults
1990-93: Retail experienced 50% defaults
2001-03: Media/Telecoms experienced 43% defaults

Source: Credit Suisse Research

22

Dynamics of a default cycle

Losses vary by issuer characteristics:
1989-90: cyclicals constituted 75% of market defaults
2001-03: cyclicals constituted 55% of market defaults
2008-09: cyclicals constituted 75% of market defaults
Smaller issues tend to default at a higher rate than larger issues, default rate
by issue size 1980-2012:
< $100m:
8%
$100-$300m: 4%
> $300m:
2%
High Yield vs. Leveraged Loans, cumulative default rates during stress
periods:
1989-90: HY 24%
2001-03: HY 38%, LL 27%
2008-09: HY 15%, LL 15%
Timing:
Defaults tend to peak 2-4 years after the start of the default cycle.
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Morgan Stanley Model: Loans Trading with

244bp in Liquidity Premium

Source: Morgan Stanley Research, Bloomberg, Moodys, S&P LCD, LSTA, IMF

24

Morgan Stanley Model: the HY Market

Paying Investors 240bp Liquidity Premium

Source: Morgan Stanley Research, Bloomberg, Moodys, S&P LCD, LSTA, IMF

25

Neither High nor Low:

Moderate Default Rates

Source: Deutsche Bank, Moodys Investor Service

26

Historical Moodys Default Rate for

Sub-Investment Grade Bonds

Source: Deutsche Bank, Moodys Investors Service

27

Default Rate and Illiquidity Premium

Components of HY Spread
Major component of US HY returns has shifted from default rate to illiquidity premium
Average Default Rate and Illiquidity Premium Components of HY Spread Over Time

Source: Credit Suisse

28

High Yield and Leveraged Loans Illiquidity

Premia and Defaults
High yield experienced larger increase in illiquidity premium than leveraged loans
High Yield
Cycle

Leveraged
Leveraged
Loans
Loans

Liquidity Default Liquidity

Premium Loss vs. Default

Cycle

Liquidity Default Liquidity

Premium Loss vs. Default

1982-2000

197

182

1.1x

1995-2005

159

110

1.4x

2001-2015

347

196

1.8x

2006-2015

234

118

2.0x

Cycle vs.
Cycle %
Change

47%

7%

Cycle vs.
Cycle %
Change

76%

8%

Year End 2015 values:

HY liquidity premium 377 bp, 1.8x larger than HY default loss rate of 213 bp
LL liquidity premium 234 bp, 3.7x larger than LL default loss rate of 63 bp
Loan default loss rate is 30% of HY default loss rates
Source: Data from Credit Suisse (Leveraged Loan Index and Default Review)

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BBB-Rated Corporates Liquidity Premium

Decomposing BBB-rated corporate spreads into default loss and liquidity premium
components over two economic cycles

BBB-Rated
Cycle

Liquidity Default Liquidity

Premium Loss vs. Default

1996-2005

65

15

4.3x

2006-2014

173

12

13.9x

166%

-18%

Cycle vs.
Cycle %
Change

Source: Merrill Lynch (Global Corporate Bond Index Spread (Baa)), Moodys global Baa-rated credit loss rate

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Average Secondary Market

Bid/Ask Spreads
2.5

Average Bid/Ask Spread, pts

2.3
2.0
1.8
1.5
1.3
1.0
0.8
0.5
May 11

Nov 11

May 12

Nov 12

May 13

30-day average US HY bid/asks

Nov 13

May 14
EM HY

Nov 14

May 15

Nov 15

EU HY

Source: Bank of America Merrill Lynch Research

31

Global Non-Financial BB and B Annual

Default Rates
Average default rate 1981- 2004 = 5.4%
Average default rate 2005-2015 = 2.4%
Decline in default rate 45%

Source: Deutsche Bank, S&P

32

Barclays US HY Index
Quality Breakdown

Note: Market Values.

Source: Barclays Research

33

US HY: Secondary market

Liquidity Conditions
1.05

Percent of Market Size (HY)

0.95
0.85
0.75
0.65
0.55

0.45
0.35
0.25
2006

2007

2008

2009

Trace HY Trading Volume

2010

2011

2012

Average (pre 6/10)

2013

2014

2015

Average (post 6/10)

Source: BofA Merrill Lynch Global Research

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