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Happy rallies are not all alike.
The fixed-income market has enjoyed a heady period of outperformance. With a total return of 11 percent through the first three quarters, long Treasury bonds are on the verge of thumping stocks for the third year in a row. Rates have dropped to levels not seen since the Kennedy era, and investors’ desire to squeeze out a predictable return has revived interest in the whole asset class.
So what’s the problem? First off, interest rate declines should make all bond investors happy, but some bonds are clearly more equal than others. In the midst of widespread investor uncertainty, most of the interest has been confined to Treasuries, arguably the safest investment in the world. Other market segments either haven’t benefited or have been subject to cruel shifts in direction. Hit by record numbers of corporate bankruptcies and credit downgradings, high-yield bonds once again posted losses in the first nine months of this year. Credit concerns have afflicted investment-grade corporates, which turned in one of their worst-ever performances relative to Treasuries in the third quarter. Mortgages? After two years of solid gains, they have been whipsawed by concerns over the impact of record refinancings and questions about how mortgage players, like Fannie Mae, manage risk. Asset-backeds have had to contend with worries about off-balance-sheet financing and ballooning consumer debt.
“The decline in Treasury yields has kept the entire fixed-income sector in play,” says John Atkins, an analyst at IDEAglobal, an independent research firm. Not always with great results.
In July and August a big chunk of the fixed-income market sold off as fears of global banking contagion, a double-dip U.S. recession and more corporate failures suddenly took hold. “Any position except Treasuries was a loser,” says Atkins.
But even investors who were long Treasuries got burned when the Securities and Exchange Commission’s newly set date for U.S. chief executives to certify their companies’ financial statements passed uneventfully on August 14. A brief, sharp downturn in Treasuries left a number of firms with losses.
“From a traditional point of view, it was a great period for Treasuries and mortgages, but because volatility is very high, Treasuries have been very difficult to trade,” says Dominic Konstam, head of interest rate research at Credit Suisse First Boston. “Traders have to be very careful about positioning; it is not a good trading environment.”
In these treacherous circumstances any sign of trouble can cause bonds to tumble. Last month the debt of AT&T Wireless Services, Ford Motor Co. and Sprint Corp. all traded down sharply when worries about credit quality prompted investors to flee. In Ford’s case the doubts proved justified while through late October concerns about AT&T and Sprint haven’t presaged any ratings changes. “Market sentiment has been pushing spreads around, not fundamentals,” says Paul Huchro, head of corporate trading at Goldman, Sachs & Co.
Even selecting the right sector wasn’t always helpful this year. Emerging-markets debt was a winner -- but only if Latin America was excluded. NonLatin American emerging debt chalked up a healthy 16.4 percent gain through early October. But add in Latin American issues -- thus capturing Argentina’s default and worries about Brazil’s economic future -- and returns fell to a more meager 2.5 percent.
Market volatility scorched the bottom line at many brokerages, which are already reeling from a horrid stock market and reduced deal making. Thanks to a decline in principal transactions and a 20 percent falloff in bond trading revenues, bond powerhouse Lehman Brothers’ net earnings fell 37 percent in the third quarter, to $194 million, the sixth drop in seven quarters. J.P. Morgan announced third-quarter income plunged 91 percent from losses arising in part from fixed-income trading.
Not everyone suffered, though. Goldman Sachs booked a 12 percent gain in net income in the third quarter thanks to record revenues of $1.31 billion (an increase of 19 percent) from fixed-income, currency and commodities trading. Goldman reportedly did not maintain as much corporate bond inventory as some of its rivals and managed to play the August Treasury rally well.
With investment banking activity sharply down and investors buying fewer shares, firms must rely increasingly on the prowess of their bond traders. “A greater percentage of these firms’ profits is coming from fixed-income businesses,” says Brad Hintz, a brokerage analyst at Sanford C. Bernstein & Co. “They are increasing their value at risk, which increases volatility in earnings.” Hintz expects fixed income’s share of overall earnings to jump from 40 percent a year ago to 66 percent at Bear, Stearns & Co. and from 42 percent to 61 percent at Goldman.
For all the volatility in the markets, though, the leaders in Institutional Investor‘s eighth annual fixed-income trading poll remain unchanged. Citigroup/Salomon Smith Barney retains first place overall for the fourth year in a row in the opinion of the traders and portfolio managers surveyed by Institutional Investor. Lehman Brothers and Merrill Lynch & Co. hold on to second and third place, respectively.
Further down, the rankings shift. UBS Warburg surges from eighth to fourth place. Credit Suisse First Boston climbs two spots to fifth, and Deutsche Bank advances one place to ninth. On the downside, despite its strong trading results, buy-siders don’t rate Goldman as highly this year; the firm drops from fourth to seventh place. Also losing ground: Morgan Stanley, which descends a notch to sixth; J.P. Morgan, which falls two places to eighth; and Bear Stearns, which slips from ninth to tenth.
All of these dealers are laboring in a very difficult economic environment. Fiscal and monetary stimuli haven’t ignited the expected U.S. economic recovery. Instead, there is increasing concern that a double-dip recession may be getting under way. And the economy’s seesawing only adds to investor uncertainty. GDP grew at a 5 percent annualized rate in the first quarter of 2002, only to slow to a measly 1.3 percent in the second. Growth is expected to surge to about 4 percent for the third quarter and then sag again late in the year.
This uncertainty has been a boon for safe-haven Treasuries, where ten-year rates this year had fallen from more than 5 percent to 3.6 percent by early October. But it has been devastating to corporate earnings and now threatens the U.S. consumer, whose spending has kept the economy afloat. With Treasury yields at 40-year lows, there isn’t much room left to stimulate growth. “The world is a much more complex, dangerous place; in this environment you have to be on your toes,” says Doug DeMartin, Merrill Lynch’s head of global credit markets. “The price of admission into this business is higher than ever because of the change in the competitive landscape, and that has required people to accept more risk and invest more capital.”
Few areas have been riskier than corporate bonds. Extreme volatility combined with a lack of liquidity means that instead of costing a few basis points, mistakes can end up costing hundreds. Mark MacQueen, portfolio manager and trader at Austin, Texasbased Sage Advisory Services, an investment adviser with $2 billion under management, notes that “an A-rated security can move in hyperspeed to default in a few weeks.” That’s a big change from a year or two ago. Enron Corp. was still rated investment-grade a month before it declared bankruptcy, for example, as were Kmart Corp., NRG Energy and Southern California Edison Co.
“This is definitely the least liquid, most volatile market that any credit trader has had to deal with,” says one corporate bond trader. “Credit markets are trading off so much information -- equities, derivatives, options volatility -- that it makes for violent moves.”
Ford Motor’s BBB+-rated debt securities, for example, traded at 300 to 400 basis points over comparable Treasuries before worries about underfunded pension liabilities, Ford’s financing arm and a possible rating downgrade widened that spread to nearly 600 basis points early last month; some isolated trades at the height of the worry were as high as 800 basis points over Treasuries, well into junk territory. (Standard & Poor’s downgraded Ford to BBB late last month.) In contrast, companies like AA-rated Wal-Mart Stores with little debt and solid business prospects have traded at spreads closer to 40 basis points.
Agencies held up well much of the year when the yield curve was steepening. But even that usually safe market had its troubled moments. When government-sponsored mortgage investor Fannie Mae reported in September that its duration gap (the relative interest rate sensitivity of its assets and liabilities) had reached its widest level ever, it highlighted the risks that government-sponsored enterprises face and those they present for others. Fannie Mae’s mortgage portfolio accounts for more than one quarter of the mortgage index; its need to balance the duration of its assets and liabilities has made it one of the biggest players in the derivative markets, and the amount of its outstanding debt is almost one fourth the size of the Treasury market.
In anticipation of Fannie buying mortgages, banks, which had pulled back from purchasing the securities when the yield curve flattened, moved back into the market. They had to unwind those positions once Fannie narrowed its duration gap. “Fannie Mae is part of the reason banks are shying away from buying mortgages now,” says CSFB’s Konstam.
Thomas Maheras, head of global fixed income at Citi/SSB, worries that dealers and investors aren’t sufficiently aware of the new stresses. The mortgage market, for instance, has grown explosively in recent years while Treasury issuance has remained stable. When rates rise again, the mortgage market’s expanded hedging needs may amplify the rise in interest rates, causing dislocations in other sectors. “The real question is can the market handle another major shock -- is the structure better prepared to handle shocks than it was in 1994,” he says. That year, of course, was the worst in recorded bond market history; it featured the blowup of several funds, including the $630 million mortgage-backed hedge fund run by David Askin. Last month saw a similar calamity in the trading world when Beacon Hill Asset Management announced losses of more than $400 million because of bad mortgage-backed and Treasury bets.
The record number of corporate failures has also prompted questions about the “superbank model,” exemplified by commercial and investment banking giants like J.P. Morgan Chase & Co. and Citigroup. The assumption was that these superbanks could use their lending power and massive balance sheets to attract more-lucrative underwriting business and ultimately leverage these two strengths into more powerful, knowledgeable trading operations. Citigroup, for instance, has successfully climbed to the top of the underwriting league tables.
“Competition is extreme, and universal banks have made some inroads,” concedes Merrill’s DeMartin. But he and other traders at traditional investment banks remain skeptical of the big banks’ strategy. They snipe that the aggressive approach to underwriting has left the banks with multiple exposures to troubled, or even bankrupt, borrowers like Enron and WorldCom.
“Their approach has helped them in the league tables this year,” says Goldman’s Huchro. “But our renewed focus on our customer franchise, our early integration of cash and credit derivatives and our prudent risk management system have helped us compete very effectively in the overall corporate trading business.”
Predictably, the megabanks aren’t admitting to any setbacks. “We think the model has proven itself to be most effective with our clients,” says Citi/SSB’s Maheras. “We assemble more expertise and capability in one place than anyone else -- that’s what our clients are telling us.”
Still, their effectiveness hasn’t had a chance to prove itself in good times and bad. “There was too much optimism about the model a year ago, and there’s too much criticism now. I don’t think the model has been completely debunked, but there will have to be some changes,” says James O’Brien, co-head of cash and credit derivatives at Morgan Stanley. Superbanks, he says, must avoid taking the same credit risks in all their businesses and create a truly diversified earnings base.
To be sure, bonds have helped Wall Street firms weather the recent storms. Fixed-income departments have largely escaped the budget ax now hitting equity, research and investment banking ranks. There have even been very measured expansions in bonds or related areas like credit derivatives. “We’re trying for a bigger market share on secondary trading in investment grade, but we are trying to grow with the same number of people,” says Morgan Stanley’s O’Brien.
The bull market in bonds has also given a boost to the handful of surviving electronic trading platforms. TradeWeb, which makes our list for the first time, in the 14th position overall, has seen trading volume grow to a record $1 trillion a month across nine sectors in the U.S. and Europe. “It is no longer a new concept -- we are seeing the age-old idea that liquidity begets liquidity,” says Tom Eady, who runs TradeWeb’s sales and marketing. And, as much of the bond market has rediscovered this year, illiquidity begets illiquidity.
HOW WE DETERMINE WINNERS
Institutional Investor conducted phone interviews with traders and portfolio managers drawn from the 300 largest money management firms in the U.S. Respondents were asked to pick the top three firms relative to their trading of fixed-income securities in each of 20 different cash or derivatives products.
For all the categories, interim results were generated by awarding 3 points for a first-place vote, 2 points for second and 1 point for third. Those raw numbers were then weighted using an II formula that assigns a greater value to larger money management institutions. Although only the top firms in each individual category are listed, in computing the top 20 ranking, firms were credited for each vote they received, excluding high-yield sectors. A separate ranking highlights the top ten firms in high-yield trading.
