Usually when I see the words ‘fixed income’, I immediately think two things: low risk and low return. From what I have learned and extrapolated in my finance classes, bonds and other such fixed income securities are used as safe assets in investors’ portfolio, ‘guaranteeing’ (I use that word loosely) a steady, relatively low level of income. As I found out to my surprise today though, the low level of income may only be the case for individual investors. The buying and selling of bonds, currencies, and commodities (collectively known as FICC) have accounted for more than half of investment banks’ revenue in recent years! Take a look at the following graph:
Unfortunately for investment banks, however, that fraction has been dropping since 2009. As a recent article in the Economist, “The Engine of Investment Banking is Spluttering,” explains,
“In 2009 the world’s big investment banks earned nearly $142 billion from FICC—63% of their total revenue, according to Coalition, a data firm. By last year that had halved to nearly $74 billion, accounting for slightly less than half of revenue (see chart). In 2013 alone revenues from FICC fell by almost 20%.”
The article goes on to point out that this trend has not stopped in 2014. Across the world, investment banks’ fixed income revenues have fallen and this drop has been most prominent in Europe:
“Huw van Steenis, an analyst at Morgan Stanley, reckons Europe’s leading investment banks gave up about five percentage points of market share in FICC to the three leading American banks last year.”
A valid question to ask is why is this happening?
There seem to be two main reasons. The first is a cyclical argument, justifying the drop in FI revenue because of current economic policy. The second reason is related to increased financial regulation. I will discuss both of these reasons below.
The Cyclical Argument
From an economic policy perspective, the first four months of 2014 have been characterized by the Fed’s QE tapering and adoption of forward guidance, which is the name given to the Fed’s recent efforts to keep long term interest rates low. This effort is mostly driven by the Fed’s economic forecasts and communications with the public. So how does this relate to low fixed income revenues? Stable and low interest rates make for slim bond trading profits. Low interest rates mean that bond prices are relatively high and stability means that banks have less chance to take advantage of price changes.
The Regulation Argument
Although this argument relates more to Europe (Swiss banks are especially stringent), it is also relevant to the rest of the world. Generally speaking, financial regulation is becoming more restrictive globally. Banks are required to hold more capital in order to trade, the U.S. has banned banks from trading on behalf of their clients, and there has been a global effort to move derivative trading to central clearing houses. All of these things force investment banks’ profits down.
I think the main effect this decrease in fixed income revenue will cause is a shift on the part of investment banks toward equities. However, I don’t think this shift will last very long because once the Fed starts raising interest rates again fixed income will once again be attractive because spreads will be higher.