Feb. 27 (Bloomberg) -- Fixed-income trading, Wall Street's profit engine the past five years, is decelerating and that may crimp earnings growth in 2006.

The pace of U.S. bond sales probably will drop 13 percent this year, curbed by rising interest rates, the New York-based Bond Market Association reported. While daily trading of U.S. Treasuries rose last year, the rate of gains was half what it was in 2004, data compiled by Bloomberg show. Price volatility in the $4 trillion Treasury market is the lowest since 1998 and Goldman Sachs Group Inc., the industry's No. 1 trader by revenue, put the brakes on trading risks in 2005, a sign that market opportunities may be fading.

``We cannot expect a near-perfect environment'' for trading bonds, currencies and commodities, the biggest source of revenue for the five largest securities firms, to ``carry on forever,'' said Neal Shear, head of fixed-income trading at Morgan Stanley, the industry's No. 3 firm by market value. Risks include ``rising interest rates and a major unexpected credit crisis,'' the 51-year-old Shear said in an interview from his office at the firm's headquarters in New York.

Fourteen interest rate increases by the U.S. Federal Reserve in less than two years have made new bond sales less attractive and eliminated some of the easiest and most profitable trades on Wall Street.

Total bond sales, excluding U.S. Treasuries and so-called agency securities, probably will slip to $3.56 trillion this year from $4.1 trillion in 2005, according to the Bond Market Association's survey published last month.

Earnings Outlook

Mortgage-related bond sales probably will fall 20 percent to $1.68 trillion and municipal bond issuance will decline 13 percent, the trade group said. Issues of asset-backed securities will slide for the first time since 1999, with asset-backed securities linked to home-equity loans tumbling 17 percent, according to the survey. Corporate bond sales will likely rise 1.6 percent, while debt backed by auto loans may be up 8 percent.

For all of the data pointing to a slowdown, the securities industry may so far be proving as profitable in 2006 as 2005. Members of the Bond Market Association also were bearish at the start of last year. Their pessimism proved unfounded as issuance rose about 10 percent to $4.1 trillion. The survey had predicted a drop to $3 trillion.

Bond investors are the most optimistic about Treasuries since 2003, a sign that the worst start to a year for U.S. government debt this decade may be about to end, according to Jersey City, New Jersey-based Ried, Thunberg & Co.'s weekly index on the outlook for 10-year Treasuries.

UBS's Plan

Record fixed-income trading revenue fueled combined net income of $20.5 billion last year for Merrill Lynch & Co., Goldman, Morgan Stanley, Lehman Brothers Holdings Inc. and Bear Stearns Cos., up 19 percent from the all-time highs of 2004. All the firms are based in New York.

Analysts Brad Hintz of Sanford C. Bernstein & Co. and Lauren Smith of Keefe, Bruyette & Woods Inc. increased their earnings estimates for firms including Goldman for the fiscal quarter that ends tomorrow, citing in part commodities trading and a seasonal pickup in the debt markets. The first quarter is typically the busiest for bond traders.

Signs of a slowdown haven't deterred UBS AG from wanting a bigger piece of the fixed-income trading pie. Peter Wuffli, chief executive officer of Zurich-based UBS, told reporters Feb. 14 that he plans to hire fixed-income traders and increase risk- taking. Investment bank head Huw Jenkins, 48, plans to spend more than $100 million over several years to build out the bundling and trading of fixed-income, commodities, and emerging markets securities.

Alpha Plan

Similarly, Barclays Capital, the securities unit of London- based Barclays Plc, singled out credit derivatives, commodities and structured equity products in its so-called alpha plan of investments in fast-growing businesses two years ago, said unit head Robert Diamond, 54. ``We'd expect those three asset classes to have continued growth over the next couple of years,'' he said in a Feb. 21 interview.

Investors have rewarded the most fixed-income dependent firms. Shares of Goldman, Lehman and Bear Stearns are at all- time highs, while Merrill and Morgan Stanley, which are more reliant on equity-related fees, have failed to surpass records set five years ago.

The five biggest securities firms probably will report 5.6 percent earnings growth this year, down from 19 percent in 2005, according to the average estimates of analysts surveyed by Thomson Financial.

Morgan Stanley

In response to changing markets, some firms are reaching beyond bonds, mortgages and stocks. Morgan Stanley has diversified by boosting investments with the firm's own money, hiring traders of so-called credit derivatives and emerging- market debt, and supplying jet fuel to bolster energy trading, Shear said in a Feb. 23 interview.

``Our business is no longer solely reliant on whether the markets are going up or down,'' Shear said.

By the end of fiscal 2005, revenue gains from fixed income at the five biggest securities firms lagged growth in equity trading, investment banking and asset management, falling 18 percent in the final quarter from the third quarter. For the full year, the firms reported a 19 percent gain from fixed- income trading to $32 billion, compared with a 45 percent jump two years earlier. They don't break out the split between bonds, currencies and commodities.

Quarterly Swings

Quarterly swings in fixed-income trading revenue exceed those of other divisions. Combined quarter-on-quarter fixed- income trading revenue at the largest firms rose 62 percent in the first quarter, tumbled 23 percent in the second quarter, climbed 27 percent in the third quarter, and fell 18 percent in the fourth quarter.

``I'm thrilled I don't have to forecast the earnings of these companies,'' said Peter Nerby, a Jersey City, New Jersey- based analyst at Moody's Investors Service, a credit-rating company. ``Look at the firm-wide results over time. It's all you can look at.''

Goldman spokesman Michael DuVally, Lehman spokeswoman Kerrie Cohen, Merrill spokeswoman Terez Hanhan, Bear Stearns spokeswoman Renu Aldrich and Citigroup Inc. spokesman Jeremy Hughes declined to comment.

`Inflection Point'

Trading is among the most capital-intensive activities on Wall Street and often generates the biggest profits. It requires a cushion of capital, which firms use to support risk taking and a larger pool of assets.

Lehman, for instance, had $410 billion of assets as of Nov. 30 supported by $15.6 billion of shareholders' equity. The firm delivered profit for the year of $3.26 billion and a return on equity, measuring how efficiently the firm invests its equity, of 21.6 percent, up from 17.9 percent a year earlier.

``We're at an inflection point where the fixed-income markets aren't going to give you the tailwinds you've had in the past,'' said Charles Peabody, an analyst at Portales Partners LLC in New York. ``The fixed-income markets have been on an incredible bull run but over a three- to five-year horizon what you've seen is going to reverse itself.''

Goldman, the second-biggest U.S. securities firm by market value, reported Dec. 15 that it capped risk-taking on commodities during the year and scaled back currency-trading risk. The firm's growth in overall value-at-risk, a barometer of where it sees trading opportunities, slowed in each of the past two years to 4.5 percent in 2005. Equity- and commodity-related risk rose, while interest-rate and currency risk were trimmed.

Goldman's Mix

Goldman's trading revenue mix in 2005 was about 52 percent from fixed income, with more than half in the U.S., 17 percent from commodities, 7 percent from currencies and 24 percent from equities principal transactions, according to estimates from Hintz at New York-based Sanford C. Bernstein.

Ominous signs for fixed-income trading are emerging as firms announce share buybacks, as opposed to using their capital to increase their bets, Hintz said. Every dollar bought back is a reduction of $16 to $20 in balance-sheet capacity, he said.

Goldman said in December that it bought back 63.7 million shares in 2005, leaving 42.7 million shares authorized for repurchase. Lehman announced plans in January to buy back as many as 55 million shares, or 20 percent of the total, this year. Merrill today said it will buy back as much as $6 billion of stock in the firm's biggest-ever share repurchase.

Market `Headwinds'

``Why would you buy back shares if you thought fixed-income trading was going to do well?'' Hintz said. ``The first quarter will be fine, but there are headwinds in the trading environment and those headwinds will get worse through 2006.''

Declining volatility and low inflation have dissuaded brokerage customers such as pension funds from buying and selling debt and made it more difficult for securities firms to profit from making their own bets, said David Gilmore, a partner at Foreign Exchange Analytics consultancy in Essex, Connecticut.

Higher Federal Reserve rates have pushed yields on two-year notes above 10-year Treasuries, causing the yield curve to invert. A yield curve is a chart consisting of bond yields of different maturities. Ten-year notes today yield 14 basis points, or 0.14 percentage points, less than two-year notes. Yields for 10-year notes were as much as 274 basis points higher than those of two-year notes in August 2003.

That has eroded Wall Street's traditional so-called carry trade of borrowing at short-term rates, using the returns to buy riskier long-term debt offering higher returns, and pocketing the difference. It also implies investors are underestimating the risks of long-term investments, meaning demand for bonds will dry up as soon as inflation accelerates, Gilmore said.

Hedge Funds

``It's become virtually an unprofitable period for most institutions trading major currencies and government bonds,'' Gilmore said. ``The real opportunity has come from commodities, global equities and emerging markets.''

Industry executives pooh-poohed the idea that growth may slow. Fixed-income holdings worldwide probably will reach $28 trillion by the end of 2009, after rising 63 percent to $21 trillion last year from 2000, Lehman Chief Administrative Officer David Goldfarb, 48, told investors on Jan. 31 at a conference in New York organized by Citigroup.

The market is expanding as demand from hedge funds increases and more companies outside the U.S. sell bonds rather than take out bank loans, Goldfarb said. Companies in Europe and Asia use loans for more than 80 percent of their debt financing, compared with less than 20 percent in the U.S., he said.

``Across rates, commodities, currencies, credit, there is just a whole lot of activity going on,'' said Goldman Chief Financial Officer David Viniar, 50, speaking at an industry conference on Feb. 10. The boom applies to ``almost every market with the possible exception of the mortgage market, which is a little bit slower,'' he said.

Tech Bubble

January marked the biggest month for corporate bond sales in the U.S. since at least 2001. Sales reached $97 billion, almost double last year's monthly average, according to Bloomberg data. That volume roughly halved this month.

Bond trading was immune to the bursting of the technology stock bubble in 2000, which resulted in three years of shrinking revenue from investment banking and equities. Debt issues and trading boomed as the Federal Reserve slashed interest rates to 40-year lows and companies locked in cheap borrowing costs. Meanwhile, oil prices doubled and the dollar fell as much as 63 percent against the euro.

Morgan Stanley's revenue from fixed-income trading surged 22 percent last year to $6.8 billion after almost stalling a year earlier. That compares with gains last year of 16 percent to $8.5 billion at Goldman, 28 percent to $7.3 billion at Lehman, 21 percent to $6.3 billion at Merrill, and 2 percent to $3.3 billion at Bear Stearns.

JPMorgan's Stumble

Debt-trading revenue by the independent U.S. securities firms is dwarfed by New York-based Citigroup, the biggest U.S. bank and the world's No. 1 underwriter of international bonds. Citigroup's revenue from fixed-income trading rose 4.9 percent to $9.6 billion, accounting for 11 percent of the bank's total.

The No. 2 fixed-income trader last year was Frankfurt-based Deutsche Bank AG, chalking up about $8.9 billion in revenue. Citigroup and Deutsche Bank both made less money from trading equities than Goldman, Morgan Stanley and Merrill.

Fourth-quarter fixed-income trading revenue at New York- based JPMorgan Chase & Co., the No. 3 U.S. bank, plunged 65 percent from the third quarter. The business accounted for $5.7 billion, or 10 percent, of the bank's revenue in 2005.

``Several of our trading books were on the wrong side of interest rates,'' JPMorgan Chief Executive Officer James Dimon, 49, said on a Jan. 18 conference call with reporters. ``It was a bunch of positions that didn't work out.''

Executive Rewards

As trading revenue climbed during the past five years, bonuses were showered on specialists in the commodities, mortgage and so-called collateralized debt obligation markets. In 2002, Goldman's fixed-income head Lloyd Blankfein, 51, earned $16.1 million, or $4 million more than CEO Henry Paulson, 59.

Wall Street also rewards success with promotions. Blankfein became Paulson's deputy in 2003, while his former co-head of fixed income, Jon Winkelried, 46, is now a co-head of investment banking and Gary Cohn, 45, a fellow commodities trader, had a stint running equities and then became co-head of equities and fixed income.

Blankfein's move was matched by Morgan Stanley's Zoe Cruz, a currency trader who ran fixed income for five years starting in 2000. Cruz, 51, was the most senior executive to survive management reorganizations last year by former CEO Philip Purcell and his replacement John Mack. Cruz, who was paid $17.5 million in 2004, was named co-president of the No. 3 U.S. securities firm on Feb. 8. Shear took over fixed income after running commodities.

Mortgage Market

Bond sales are slackening after the Fed raised rates 14 times since June 2004. Worldwide debt sales rose 6.6 percent to $2.5 trillion in 2005, down from 10 percent growth in 2004 and a 35 percent increase in 2003, Bloomberg data show.

While the value of collateralized mortgage obligations issued by the top 10 underwriters surged 32 percent to $757 billion last year, it slipped 6 percent in the fourth quarter.

Mortgage bond trading volume tumbled by almost two thirds in the fourth quarter in a seasonal slowdown from records in the first three periods, according to an index of daily activity by U.S. primary dealers. Bear Stearns was the No. 1 underwriter of CMOs last year, according to Bloomberg data.

``Rising interest rates will hurt interest-rate sensitive sectors such as housing and refunding activity in the municipal bond market the most,'' Micah S. Green, president of the Bond Market Association, said last month.

As parts of the debt markets sputter, firms have turned to commodities, tailor-made debt securities such as credit-default swaps, and less easily traded investments.

Power Plants

Financial firms generated $8 billion in commodities-related revenue in 2004, up from less than $1 billion 10 years earlier, according to estimates by analyst Hintz. Market leaders Goldman and Morgan Stanley each get more than $1 billion a year from energy trading, he estimates.

Morgan Stanley won approval this month from U.K. regulators to supply electricity directly to British factories. Merrill bought Houston's Entergy-Koch LP in 2004 and Lehman started its own energy unit late last year.

The market for credit derivatives, which is dominated by contracts insuring debt against default, has grown five-fold in two years to $12.4 trillion, according to the New York-based International Swaps and Derivatives Association. JPMorgan, Deutsche Bank, Goldman, Morgan Stanley and Merrill are the five most frequent traders of credit derivatives, according to Fitch Ratings.

Derivative Market

The U.S. market for collateralized debt obligations, derivatives that bundle together assets ranging from mortgages to loans to high-yield bonds, more than doubled to about $290 billion during the past five years. A derivative is a financial obligation whose value is tied to interest rates, the outcome of specific events, or the price of underlying assets such as debt or oil.

While equity trading revenue probably will rise 15 percent this year and merger fees will be up more than 20 percent to a record, fixed-income trading will probably rise ``a more modest 5 percent,'' said Sandler O'Neill & Partners LP analyst Jeffery Harte in Chicago.

To contact the reporter on this story: Adrian Cox in London at acox2@bloomberg.net

Last Updated: February 27, 2006 10:32 EST