What Wall Street’s earnings results tell us about credit market opportunities.
by Brad Tank, CIO, Fixed income, Neuberger Berman
In the now-distant past, when a financial market went through a bout of volatility, the intermediaries who trade securities to provide liquidity for that market tended to clean up.
It’s well known now that regulatory change, the rise of electronic trading and evolving management practices have converged to reduce risk-taking on the part of these market-makers.
Going back to 2010, the International Monetary Fund (IMF), the Federal Reserve Bank of New York and others have documented this in numerous studies, looking at dealer balance sheet size, trading volumes, bid-offer spreads, market volatility and other pertinent factors.
After a 75% decline between 2008 and 2010, dealer corporate bond balance sheets have generally flat lined while trading volumes have trended higher; over recent years, bid-offer spreads have also generally moved wider.
In the past, higher trading volumes with wider spreads in Q4 2018 would have suggested that we’d see decent trading results from the dealers on the Street—in fact, we have seen quite the opposite.
Poor Results for Trading Desks
Fourth-quarter earnings reports reveal that, at Bank of America, fixed income trading revenue was down 15%. At Citi, it was down 21%. JPMorgan, which posted its worst bond-trading quarter since 2008, saw revenues fall 18%, the same decline experienced by Goldman Sachs and Morgan Stanley. Deutsche Bank’s slumped by 23%.
I cannot recall a period of similar volatility in bond markets that was followed by such poor trading results. Colleagues trading for our bond portfolios confirm what these numbers suggest: the Street closed up shop through December, and virtually all trades had to be executed on an agency basis.
Clearly there were seasonal dynamics as the sell-off snowballed into the holidays. But it is equally clear that structural change since the financial crisis, including the impact of the Volcker Rule and Basel III, has led to a collapse in banks’ ability to warehouse securities and deploy balance sheet liquidity for market participants. The additional factor of management choosing not to trade also loomed large.
While on average dealers reported decent trading volumes for the quarter, given all that was happening in the markets it is easy to argue that they should have been substantially higher.
Unwillingness to trade was probably due to a combination of banks trying to preserve what for most had been a pretty good year with a stock market unwilling to reward risk-taking, evidenced by declining price-to-earnings multiples throughout 2018.
We have seen this before. The start of 2016 came with high expectations of an imminent global slowdown. Just like today, those expressing concern pointed to a confluence of general bad news on China and oil prices with the perceived signals from widening credit spreads and equity market volatility. They played down ground-level fundamental indicators such as housing starts or consumer confidence, which appeared robust.
Three years later, it is clear that financial markets were flashing false signals. As they flashed, more investors tried to sell into illiquid markets, and the signals flashed more urgently.
Bouts of volatility will likely be more frequent and violent, therefore, and that means economic forecasting models built on financial market indicators are now likely to be wrongly calibrated.
As in 2016, last December a number of fundamental economic factors, particularly in the U.S., seemed robust, but risk appetite had evaporated and new bond issuance was on hold. That technical picture set the scene for a major bounce, as we saw through January.
To benefit, an investor needed the flexibility to provide liquidity when it was most in demand, but also had to look through the market’s false signals to find the conviction to do so.
Flexibility can come through robust portfolio construction, with an emphasis on liquidity management. In practice, that means even a pure high yield portfolio would need bonds that can be sold in just about any conditions, alongside a focus on forward cash flow from nominally illiquid assets; in multi-sector portfolios, mortgages, which can generate ample cash from both coupons and amortization, may have an interesting role to play, for example. These can be boring ways to facilitate some exciting opportunism.
Dealers’ unwillingness to trade is ultimately an opportunity for traditional long-term investors to step in and fill the void, at what could later prove to be very attractive prices. With the view expressed in our latest Fixed Income Quarterly Outlook calling for a “soft landing” for the U.S. economy, we had the confidence to do just that with many of the bond portfolios that we are responsible for here at Neuberger Berman.
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