U.S. Fixed Income: Best of times for institutional investors

Tuesday, August 9, 2011 Stamford, CT USA — Institutional investors in U.S. fixed-income markets might be enjoying a high-water mark in terms of the intensity and quality of service they receive from dealers and even the favorable pricing they are now receiving on trades.

The reason: Financial institutions both domestic and foreign have been investing heavily to build out fixed-income platforms over the past several years. These firms are now competing aggressively for institutional trading business — much to the benefit of the buy side. With more dealers pitching their services, institutions have added new sell-side trading relationships and are spreading their trading volume among a broader group of dealers, all equipped with robust capabilities and all working hard to win business. The result: Despite the loss of three major investment banks from the U.S. market during the crisis, the number of fixed-income dealers (actively) used by the typical U.S. institution has returned to pre-crisis levels as institutions form new relationships with up-and-coming U.S. firms and foreign competitors eager to expand their footprint in the United States.

From 2010 to 2011, the top five U.S. fixed-income dealers as a group saw their market share in institutional trading decline by about 2.8%. Meanwhile, dealers below the top five increased their collective market share by 3.3%. Even among the bulge bracket brokers, institutions have been spreading their trading business more broadly. In 2011, no fewer than three dealers — Barclays Capital, Deutsche Bank and J.P. Morgan — are deadlocked at the top of the market with market shares in institutional trading of roughly 11.5%. Two firms, Goldman Sachs and Citi, follow close behind with market shares topping 10%. These firms are the 2011 Greenwich Share Leaders in U.S. Fixed Income, Overall Market.

Two factors raise questions about the sustainability of the current market dynamic and Greenwich Associates warns market participants not to get too comfortable with the levels of pricing and service they are now enjoying.

Although U.S. fixed-income trading volume increased roughly 10% from 2010 to 2011, trading activity suffered from periodic disruptions due to the European government debt crisis and other events, and sell-side trading revenues fell short of expectations. Activity picked up in the first quarter of 2011, but dealers reported disappointing trading volumes in the first two months of Q2. If trading revenues do not rebound to levels required to support newly expanded platforms, some dealers will be force to cut costs.

Regulatory reform remains a wildcard for the sell-side. Many of the basic questions that will determine the business models and strategies of the world's largest financial institutions remain unanswered. Regulators' final rulings on these issues will determine the profitability of various investment banking and capital markets activities, which will in turn determine the amount of resources and balance sheet firms will devote to activities such as institutional fixed-income trading. "Until these questions are answered, it's impossible to predict with any certainty how institutions will be affected by regulatory changes in terms of pricing, liquidity, sell-side capital commitment or levels and quality of sales coverage and research service," explains Greenwich Associates consultant Frank Feenstra.

For now, however, U.S. institutions should enjoy what could be the best of times in terms of dealer coverage. And make no mistake: there is a possibility that these favorable conditions will last for some time to come as a widening group of dealers continue to fight for business. "Over a longer term, everything will depend on how changes in market structure and composition ultimately affect dealer profitability," says Greenwich Associates consultant Woody Canaday. "The market's shift in emphasis from structured products to rates products has already reduced the profitability of fixed income for sell-side firms, and the restructuring of the derivatives market could put further pressure on dealer margins. With fixed-income units becoming more dependent on liquid, transparent and lower margin business, sell-side firms need to see a relatively quick rebound in trading volumes if they hope to support their platforms at current levels."

Government Bonds Drive 10% Increase in Institutional Trading Volume

A 10% increase in U.S. fixed-income trading volume last year was driven mainly by a surge in institutional trading of government bonds. (That increase is based on volume totals reported by a matched sample of institutions interviewed by Greenwich Associates in both 2010 and 2011.) Fixed-income assets under management by U.S. institutions experienced an even more dramatic increase — expanding by approximately 30% to nearly $6 trillion. Trading volume in U.S. treasuries increased almost 60% from 2010 to 2011. Significant increases in government bond trading volume were reported by institutions of all sizes and types. As a result of these and other shifts in trading volume, government bonds now represent about 21% of the U.S. fixed-income market in terms of trading volume, up from 18% in 2010, and rates products as a whole, including interest rate derivatives and mortgage-backed pass-through securities, now make up nearly 80% of the U.S. fixed-income market.

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