The Federal Reserves recently announced move to raise interest rates will be the first interest rate hike in a decade. But in bond trading, rising rates will meet a vastly different bond market than the one that existed 10 years ago.
Rises in interest rates typically lead to more trading activity. JPMorgan CFO Marianne Lake told an investor conference in December that the bank expects rate hikes to boost trading volumes in 2016. But after several years of lowered bond revenues, many big banks have tempered their enthusiasm.
Colm Kelleher, head of Morgan Stanleys investment banking business, told an investor conference in November that the fourth quarter of 2015 could be the low point for fixed-income revenues, suggesting that next year things might turn upward. Despite Kellehers assessment, Morgan Stanley announced weeks later that it was slashing up to a quarter of fixed-income jobs. The problem may be best summarized by Kellehers conference remarks: We believe having a credibly sized and critical-sized fixed-income business is a must to be a bulge-bracket bank. The question is, what is that size?
Kelleher noted that the fee pool in fixed income, historically assumed to be $160 billion to $150 billion, has for the last few years been around $100 billion or less.
A reason firms may not expect much turnaround in fixed-income revenues may be the bond markets structural changes over the past decade, according to Anthony Perrotta, Jr., head of fixed-income research at Tabb Group.
Perrotta said that rather than look at FICC revenues, a more telling picture of todays bond market can be seen in the statistics about the rise of riskless principal trading. In U.S. corporate bond markets in 2006, 5 percent of investment-grade bonds and 20 percent of high-yield bonds were traded through riskless principal trading. In 2015, riskless principal trading had shot up to 30 percent of investment-grade U.S. corporate bond trading and 70 percent of high-yield, according to Tabb Group data.
In riskless principal trading, trades are not executed unless both sides of the trade are lined up. The effect is similar to agency trading, but with a different fee structure. Prompted partly by post-financial-crisis capital adequacy rules that make it harder for firms to hold large bond inventories, the sharp rise of riskless principal trading translates into a drop in traditional bond trading, where firms put forth principal to make markets.
Other factors are affecting bond markets. Increased transparency may have narrowed spreads, as counterparties have more visibility into prices. Bond markets are in varying stages of electronification, with high rates of e-trading in treasury markets and less in corporates.
In fact, Perrotta believes the unevenness in the technological capabilities, combined with a new market structure where banks are doing less principal trading, may cause bond market volatility to be extreme rather than gradual in the coming year. The stabilizing effect on markets of traditional market-making is now diminished. As prices move, highly automated traders can fulfill their needs at one price and speedily move on to another. That leaves fewer automated traders to watch prices move quickly.
What that causes is a domino effect of trading getting done at a wider array of prices rather than more trading around a single price, said Perrotta.
