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Has the Appetite for Risk Returned?

The year 2012 was a busy one for risky debt. The total value of the various forms of risky debt that were issued - corporate debt, asset-backed securities, collateralized debt obligations, and municipal debt in particular - grew substantially over the previous year, while yield spreads for these instruments decreased.

The drop in yields coupled with the increase in issuance signals that funds suppliers are willing to supply more funds at each yield. Fed policies might be one of the factors behind this increase in willingness, as one goal of the Fed's asset purchase policy is to increase credit to private-sector investments such as corporate debt. The increased issuance size coupled with decreasing yields made 2012 a borrower's market. Firms issued more debt to take advantage of the lower yields, while investors handed more of their funds to these firms, even though promised yields were lower.

There are two risk categories of corporate debt, and while both have grown, the riskier type has bounced back even stronger. Investment-grade corporate debt is the debt of companies that are deemed safer, and it is rated by S&P as BBB- and higher. Issuances of investment-grade corporate debt were almost flat from 2010 to 2011, but they increased 30 percent in 2012. On the other hand, high-yield corporate debt, the riskier type, decreased 15 percent from 2010 to 2011 but experienced a huge surge of 47 percent in 2012.

As for yield spreads, the spread for investment-grade debt over U.S. treasuries hovered close to 2 percent until July 2011, it peaked at about 3 percent in January 2012, and it declined to slightly lower than 2 percent later in the year. High-yield spreads were more volatile, fluctuating and bottoming out in the first half of 2011, surging by almost 60 percent in the second half of 2011 to about 8 percent, and experiencing a decline in 2012 to end close to the lows of 2011 by year-end. It is particularly striking to note that yields were actually dropping in 2012, as issuances were increasing at this high pace.

Corporate Debt Issuance: Investment Grade
Corporate Debt Issuance: High Yield
Corporate Debt Effective Yield Spread

Asset-backed securities (ABSs) - debt instruments backed by auto loans, credit card debt, home equity loans, and student loans - have been expanding since 2010. In 2011 they increased 17 percent over the previous year but they surged 58 percent in 2012. ABS yield spreads over treasuries declined until they bottomed in first half of 2011. They increased in the second half of 2011 but have been declining in 2012. It is again noteworthy to mention the declining yields with surging issuances.

Asset-Backed Security Issuance
ABS Effective Yield Spread

Collateralized debt obligations (CDOs) are the notorious debt instruments that wreaked havoc during the crisis. CDOs are similar to ABSs, but they are usually backed by riskier debt. CDO issuances have been recovering at an increasing rate, going up in 2011 by 260 percent over 2010, and 45 percent in 2012 over 2011. Although these rates seem substantial, the level of CDO issuances is nowhere close to where it was before the last financial crisis hit.

Global CDO Issuance

Municipal issuances declined strongly from 2010 to 2011, but grew about 28 percent from 2011 to 2012, a substantial increase. Issuances in 2012 are still below the 2010 levels though. The effective yield spread for municipal debt started low in the beginning of 2010 and grew strongly in the second half of 2010, peaking at the end of the year. The spread was elevated during 2011, but then it declined and remained at lower levels in 2012, dipping slightly towards the end of 2012.

Municipal Security Issuance
Municipal Debt Effective Yield Spread

We see a clear uptick in issuances of risky loans in 2012, concurrent with a drop in spreads over treasury yields.

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