Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

Tension is building on Wall Street as fixed-income profits fall.

Big banks are struggling to lift falling debt-trading revenues, with Deutsche Bank saying that it expects industrywide profits to fall further this year. But the fixed-income trade is booming at BlackRock and other investment firms, which are capturing a greater amount of activity -- and fees -- with their ballooning credit exchange-traded fund businesses. The banks are now angling to steal some of that business back.

Deflating Trade
The biggest banks have reported declining debt-trading revenues in recent years
Source: Bloomberg Intelligence

The problem is that new rules and higher capital requirements have reduced the amount of risk that big banks can take, and they need to answer investor demand for fast easy access to a broader index of corporate debt, especially as it takes longer to trade specific bonds than it did years ago.

This speed and ease of use is the biggest appeal of the largest credit ETFs, such as a $25.4 billion BlackRock investment-grade fund that is listed as LQD and a $16 billion junk-bond fund that trades as HYG. The funds have shares that trade like stocks even though they own baskets of harder-to-trade debt. Volumes in both of these funds have surged to records in recent months even as it becomes more difficult to trade corporate bonds that aren't included in their benchmark indexes.

Wall Street's answer is the total-return swap. Here’s how the total-return swaps work: An investor pays a fee to a counterparty who promises to deliver the equivalent of the total gains on a specified basket of debt. If the debt gains value, the bullish investor receives income without having to own the underlying security. If the debt loses, the investor will have to make the counterparty whole. Not only can investors trade these agreements quickly without having to deal with the cash-bond market, but the ones now in vogue are pegged to the same indexes as the biggest credit ETFs. They are in direct competition.

Citigroup recently became the eighth dealer in these instruments, which are gaining in popularity among investors looking for faster, more efficient ways in and out of less-liquid credit markets, as Alastair Marsh and Sridhar Natarajan of Bloomberg News reported this week.

Indeed, these indexed credit total-return swaps are being pitched as an alternative to ETFs, and in some ways are riding on ETF-related activity that has made the most-liquid corporate bonds more attractive. Consider a February Citigroup report by strategist Anindya Basu as an example: He explains that these derivatives have "no tracking error," unlike ETFs that "may not always be able to replicate the whole portfolio exactly." 

He notes that investors can add more leverage using these derivatives than other instruments and can fairly easily express both bullish and bearish bets on broader credit markets. Another appeal of the total-return swaps is that traders aren't charged management fees, as they are with ETFs, according to Peter Tchir, macro strategist at Brean Capital. And they can do big trades with derivatives more quietly than with ETFs or cash, he said.

Wall Street's biggest players are climbing aboard the indexed total-return swap bandwagon. Goldman Sachs, Bank of America, JPMorgan Chase, Morgan Stanley, BNP Paribas, Credit Suisse and Deutsche Bank are all dealers in the derivatives, according to the article. Investors are taking note and increasing their use of these synthetic agreements, albeit rather slowly compared with the accelerating adoption of credit ETFs.

Given increasing restraints on trading specific bonds, big Wall Street banks are catching on that their biggest opportunity may be turning credit trading into a volume business. BlackRock showed the way by creating the first corporate-bond ETF more than a decade ago and ushering in a huge success. Now big banks are trying to figure out how to get their piece of the action.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net