Over the past 18 months, U.S. debt capital markets have experienced tremendous levels of volatility. Debt issuance has gone from "full stop" to "full steam ahead" in just over a year. Government efforts to inject liquidity and stimulate capital markets are doing just that, but with uncertain consequences.

Recently, for many classes of bonds, the general trends have been strong price appreciation, volumes of new issuance at near record highs, and simple price discovery in a very active market. Investors are gradually making their way up the risk spectrum in search of higher yield. As more signs of recovery emerge, financial institutions should be aware of how these market changes may impact their portfolio. And because of the strong effects of the stimulus programs, they should also be ready for the possibility of unintended and/or uneconomic consequences that may impact their portfolio values.

Let's examine a few key areas financial institutions should pay attention to as the debt markets recover:

Volume. With liquidity abundant and the macroeconomic outlook improving, investors' appetite for risk is increasing. They're seeking returns and are pushing the price of investment-grade and non–investment-grade corporate debt significantly higher (rising prices mean lower yields). For example, junk bond markets have gone from frozen with little activity in early 2009 to record levels of new issuances in March 2010. In fact, $35.3 billion of U.S. junk bonds were issued in March, easily surpassing the prior single-month record of $31.2 billion, in November 2006. Correspondingly, $98.3 billion in investment-grade debt was issued—not a record but still quite high.

Spreads. Spreads describe a required rate of return above a benchmark rate such as the U.S. Treasury rate, and are used to describe the yield or price on a bond. Lower spreads mean higher bond prices and a drop in spreads is a signal that investors perceive lower levels of risk for an investment. According to Standard & Poor's Global Fixed Income Research, spreads for "speculative grade" debt have fallen from over 15 percent (above a risk-free rate) in early 2009 to around 6 percent in March 2010, thanks to an improved macroeconomic outlook combined with increased demand. But the recovery hasn't been universal. Whole-loan markets, for example, haven't fully recovered. And some of the most affected market sectors such as collateralized debt obligations and private-label (non-agency) collateralized mortgage obligations remain close to frozen, with very little activity.

Whole loans. Yields for corporate debt may be a useful barometer of what's coming for whole loans, since they represent signs that investors are seeking greater returns at higher levels of risk. As investors reach even further up the risk spectrum, it's likely that the consumer and commercial whole-loan markets will be similarly impacted resulting in reduced yields (higher values). Banks will face increasing competition, and some lenders will see reduced rates of return. Compared with the corporate debt market recovery, this trend should take longer to play out, since capital levels are still being replenished in the banking system and some significant whole-loan markets haven't yet hit bottom.

Shadow banking, or non-agency securitization. There are also some signals that the "shadow" banking market is reemerging as a result of ample liquidity and a growing interest from investors seeking higher yields. One clear sign that non-banks are seeking access to the debt markets came at the end of March, when Citigroup issued the first new collateralized loan obligation securities in a year. The private (non–government-agency) mortgage-backed securitization market is off to a very cautious and slow start, with only a small volume of jumbo mortgage securitizations expected in 2010. While active trading of some legacy securities will likely never resume (such as legacy collateralized mortgage obligations with certain types of collateral and trust preferred securities of highly distressed banks), the start of a new structured finance market is in place. Although this market is reemerging, one big uncertainty here is the potential impact of pending financial reform legislation, which may place strong restrictions on this market.

Government exit strategy. Finally, the most significant unknown is what will happen as the government stimulus of debt capital markets is withdrawn. While markets have improved, much of the improvement is due to the enormous stimulus on the demand side. The Federal Reserve's purchase of $1.25 trillion in debt securities combined with a low to zero Fed Funds rate injected ample liquidity into the market. What will happen as those securities are sold and the liquidity is withdrawn from the market? And what will happen as the Federal Reserve begins to raise interest rates and credit begins to tighten? Can we achieve a soft landing without significant market disruption? As the "uneconomic" support is removed, where will the market forces of supply and demand take us within each asset type? These questions will likely dominate the next phase of debt capital market activity.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.