The trouble with fixed income trading is structural
The problems of fixed income trading are still a proxy for the fortunes of the whole investment banking industry. Fourth quarter results from the major US houses suggest the Street will have had a strong year in 2016, giving senior traders a new lease of life and a good payday, while 2017 could be just as good. But the industry’s problems aren’t going away.
2016 was a year of broken predictions and surprising results. Besides the obvious political upheavals, the usual progress of wholesale capital markets revenues was turned on its head. A miserable first quarter, a summer which boomed rather than stagnated, and then a furious flurry of trading in the fourth quarter, usually a time when clients are content to sit on their hands.
No sub-segment was better placed to take advantage of the year’s surprises than fixed income and currency trading, the powerhouse of investment banking profits for the last 15 or 20 years — and the division at the epicentre of the regulatory upheavals rocking capital markets.
Fixed income breaks down further, depending on the bank, but is often split into 'macro' and 'credit' business lines. Currencies and macro-dependent commodities line up with government bonds, bond futures, repo and public sector assets in the macro section, while credit usually embraces securitization, corporate bonds, bits of high yield and leveraged capital markets, structured credit and solutions.
In theory, these businesses work well at different times, smoothing revenue numbers. Calm markets energise credit businesses, which need predictable spreads to do difficult trades, and where banks earn money from carry, while turbulent markets (but not too turbulent) fuel macro, where revenues are driven by volume.
Unusually, last year featured plenty of both. Political turmoil provided a reason for widespread macro repositioning among investors, but more money printing in EMEA, and supportive economic news in the US, gave reasons to be cheerful in credit. That’s left investment banks looking good into year-end — FICC was up more than 10% at BAML, 31% at JP Morgan, and at Morgan Stanley, more than 200% (just over $1bn; against an unusual comparison).
Even if the European banks, which start their reporting season in two weeks, have lost a lot of market share to the US houses, this looks promising, and comes after years in which investors have wearily petitioned the likes of Deutsche Bank, Barclays, Credit Suisse and UBS to cut down on their fixed income divisions, with varying degrees of success.
More of the same?
This year looks good too, for the same broad set of reasons. Political uncertainty around defined elections will lead to flurries of trading through fat bid-offer spreads, but the basic backdrop looks supportive for more delicate credit-based activities.
But one quarter, one year, or even two years can’t hide the structural problems with fixed income trading forever.
It’s not just regulation, though that doesn’t help. It is more expensive, in risk-weight assets, for banks to hold bonds to trade, and similar regulatory assaults have hit supporting business lines, like repo, credit derivatives, interest rate swaps and FX derivatives.
Mainly, though, it’s everything else. More and more money has moved into passive accounts, or market replicating structures like exchange-traded funds. Fund managers, and their end accounts, are more fee-focused, meaning less portfolio churn and more strategies based on buying and holding.
Bonds still offer historically low yields, meaning trading costs take a larger chunk out of carry. The asset management industry is concentrating AUM in larger firms, meaning more opportunities for internal crossing of bonds. Restrictions on CDS and repo use make it harder to run short positions, negative basis trades, or to hedge existing positions.
There’s also electrification. Waiting for fixed income to start acting like the equity markets is a mug’s game, but there’s no doubt that the trading platforms, over the medium to long term, will pick up more and more of the business that used to flow through the banks and the broker-dealers.
Perhaps, as in equities, banks can adapt, running their own dark pools for bonds, using their technology skills and connections to sell order-routing algorithms to clients, or building on a foundation of public pricing and transparency to construct a new ecosystem of fixed income derivatives.
In a rising rates environment, with just the right sort of volatility, and the right blend of deal-doing, primary issuance, repositioning and repricing, fixed income divisions can once again be the stars of the show. After five years of cuts, most are lean operations, with very little marginal cost (apart from paying traders) associated with rising volumes. 2016 has been good to them, and 2017 will be as well.
But this Goldilocks backdrop won’t last forever, and then the long, slow, structural decline of the bond desks will continue.