Last checked at 
(This story originally appeared on IFR, a Thomson Reuterspublication)
By Gareth Gore
LONDON, April 28 (IFR) - The world's biggest investmentbanks are refusing to weaken their commitment to flagging fixedincome markets, choosing to sacrifice other businesses such ascommodities trading and corporate lending rather than pull backfrom an asset class where revenues have almost halved since2009.
Barclays is the latest bank to gamble on a rebound in itsflagship fixed income franchise, deciding to exit large swathesof its commodities trading operations and thereby increase itsreliance on bond trading. Rivals such as JP Morgan,Deutsche Bank, Citigroup and Morgan Stanley have made similar decisions.
The commitment to fixed income comes despite a rapid slumpin client demand over the past five years, with industry-widerevenues now back to 2005 levels and bankers complaining of alost decade due to a prolonged period of low interest rates andthe impact of tough new regulations.
Rates trading has been the worst hit, with industry-widerevenues falling to US$35bn last year from the record US$83bn in2009, according to estimates from Morgan Stanley and OliverWyman, while credit and securitised product revenues slumped toUS$37bn from US$63bn at their peak.
Further declines are expected this year if first-quarterresults are anything to go by. JP Morgan, Bank of AmericaMerrill Lynch, Citigroup and Goldman Sachs allhad their worst start to the year in fixed income since 2008.Europeans are likely to report similar declines over comingweeks.
COMEBACK
Still, the big fixed income players have largely dismissedfurther restructuring, confident that demand will return.Instead, they are choosing to boost returns through efficiencygains and meet additional capital needs by retrenching fromactivity elsewhere in their investment banks.
They argue that, despite the decline in headline revenues,fixed income still delivers decent returns because banks havedramatically cut costs over recent years. Morgan Stanley andOliver Wyman say banks have cut risk-weighted assets by abouttwo-fifths since 2009, with the axe falling heavily on fixedincome. Costs have been slashed by about a tenth, mainly throughjob losses and pay cuts.
"Today, banks generally have fewer resources allocated tofixed income than they did even four or five years ago," saidPaco Ybarra, global head of markets at Citigroup. "So whilerevenues have come down from the record year of 2009, we arequite comfortable with performance measures such asreturn-on-equity right now."
Banks are also generally confident of an eventual rebound infixed income. Interest rates are expected to begin to rise againin the US and UK over the next two years, injecting volatilityand yield back into markets, which should be good for trading.
At the same time, banks expect new opportunities to appearbetween the cracks in the regulations that have killed off manytraditional revenue streams.
"The fixed income industry is facing a number of cyclicaland secular challenges and there is a fair amount ofnavel-gazing going on right now," said Rich Herman, co-head offixed-income and currency trading at Deutsche Bank.
"There is little you can do about the cyclical challenges,you just have to ride it out, but the real challenge is tofigure out what isn't coming back."
The industry often reacts to regulatory changes by sayingthat they will be cataclysmic for the business, but experienceshows that it generally isn't all that bad. We've been through anumber of huge regulatory changes and lived to tell the tale. Itis possible the industry is being overly-pessimistic about thefuture of fixed income right now. It isn't all doom and gloom."
There are undeniable headwinds, though. Quantitative easingin the US, which has injected more than US$3trn of liquidityinto fixed income markets, is nearing its end.
At the same time, banks - especially those in Europe - needeither to cut their balance sheets or raise capital to meet newleverage rules. Barclays and Deutsche, both big fixed incomehouses, are among those worst affected by leverage restrictions.
Morgan Stanley and Oliver Wyman expect banks to withdraw afurther 6% to 8% of RWAs as they adapt to those two headwinds -cuts that should improve efficiency by slicing out the fat.
They estimate about US$1trn of balance sheet is still poorlyemployed, with up to 40% of fixed-income, currency and commodityassets tied up in rates products that yield only single-digitreturns.
That push to more efficiency could lead some smaller playerseither to retrench from fixed income or focus on niche productswithin it. Many banks are inefficient in the space, having builtup their businesses quickly to benefit from the pre-crisis boom.QE-induced liquidity kept those businesses alive, but as thatpolicy is unwound, they could be forced to reconsider.
"We have had the right incentives from the start, forcingour traders to forgo some streams of revenue if the risk-rewardisn't right for the entire business," said one fixed-income headat a US bank. "In these past few years of cheap funding, not allbanks have shown such discipline."
"I expect to see a lot of banks hanging on to theirfixed-income franchises for as long as they can, even if theydon't have the critical mass or economics to survive. But astime wears on, it is inevitable that many will be forced to cutback substantially. The let's-try-another-year strategy willwear thin."
FULL RANGE
Some banks have chosen to shrink the range of products thatthey offer within the fixed-income space - UBS and Credit Suisseare prime examples. But that is only an option for banks whosecore franchise is not fixed income - meaning the larger fixedincome houses may have to simply double down.
"We've seen a number of other banks back out of thefixed-income space," said Herman. "Generally, it is the bankswhose primary business is elsewhere - in equities or wealthmanagement, for instance. But fixed income is a core franchisefor Deutsche Bank, so we will remain committed."
Bankers argue that offering a full range of products toclients is important if they want to be taken seriously asfixed-income houses. The illiquidity of many of these productsmeans that banks, with their large balance sheets, are the onlyliquidity providers.
"Many of the assets in fixed income are not liquid enough tolend themselves to an agency model of trading," said Ybarra."Fixed-income market-making requires capital."
Banks that aren't capital constrained, such as the larger USplayers, should do well and have been winning market sharerecently over their European counterparts, many of which havemuch work to do to meet leverage rules.
Even where demand remains, however, returns on some products- especially in the rates and repo businesses - will remain lowunder new rules. Banks that continue to offer such facilitieswill have to accurately calculate how much staying in thoselow-return areas add value to the wider business.
Not all fixed income heads are optimistic, though. "TheQE-inflated bubble that led to super-sized revenues across thewhole of the fixed-income spectrum is over," said onefixed-income head at a second-tier firm.
"Volatilities are at an all-time low, rates will remain atsubdued levels for some time, and the credit cycle is reachingits peak. Fixed income is going to suffer, and anyone thatdenies that is burying their head in the sand." (Reporting by Gareth Gore, Editing by Matthew Davies)
