The healing of the U.S. credit markets and growing competition are squeezing one of the biggest sources of profits at investment banks over the past two quarters.
Trading in debt like corporate and mortgage bonds has been a boon to banks as an aversion to taking risk has kept the range of prices between bids and offers wide in the second quarter. The wider the price band, or the bid/ask spread, the greater the profit opportunity when brokering a sale.
Some spreads have now closed to their tightest levels since before the worst episodes of the financial crisis in late 2008, illustrating a technical, but key, part of the credit market recovery. Spreads will contract further if volatility ebbs, leaving banks to turn elsewhere to boost profit.
Spreads "probably will (tighten more), because banks are competitive," William Winters, co-head of JPMorgan Chase & Co's (JPM.N) investment bank, said after a press conference in New York last week.
Trading played a key role in lifting banks out of their toughest period in decades after the collapse of Lehman Brothers in September. Goldman Sachs Group Inc (GS.N), for example, this month reported $3.4 billion in second-quarter net income after trading revenue almost doubled.
Looking ahead, thinner bond trading profits mean the banking recovery, the expansion of much needed credit and the return of U.S. economic growth could be delayed.
SPREADS SHRINK AS COMPETITION GROWS
Tighter spreads are coming amid a growing playing field, where smaller firms are filling holes left by the exit in 2008 of big shops such as Bear Stearns and Lehman.
Jefferies & Co (JEF.N), Broadpoint Capital (BPSG.O), TD Securities (TD.TO) and MF Global (MF.N) are among those that have ramped up hiring in the past six months to grab market share.
"Spreads have come in, new entrants have emerged and the frequency of transactions is lower, so all of those are going to crimp profits versus the last quarter of robust profits," said Russell Certo, co-head of Broadpoint's interest rates group in New York.
That should be good news to Laurence Fink, chief executive officer of BlackRock Inc (BLK.N), who told shareholders last week that abnormally large bid/ask spreads were a "deep concern," and leading to "very luxurious returns" at dealers. BlackRock, which manages $1.3 trillion, aims to wrestle spreads lower as it adds scale, he said.
Tighter trading spreads are correlated with other positive trends -- such as smaller risk premiums as measured by bond yields -- that are following signs of economic rebound and support from U.S. government programs. As sentiment improves and volatility ebbs, the bid/ask should shrink because dealers take less risk in trading and more are willing to make markets for investors.
In commercial mortgage-backed securities, for example, bid/ask spreads have returned to 20 basis points, around levels of mid-2008, from as much as 100 basis points at the depths of the credit crisis in late 2008, according to one dealer. Yield spread premiums on CMBS have declined to near 600 basis points -- less than half their peak in November.
Commercial mortgage bond bid/ask spreads were as little as 2 basis points to 4 basis points in 2006 and early 2007.
Banks can still profit as more demand in credit markets reduces yield spreads on inventory, and because they can fund themselves at levels close to zero, analysts said. A return to record tight trading spreads may never occur, meantime, given a new, lower floor to what traders consider acceptable risks.
"I don't know if the bid/ask will tighten back to where it was in 2006," said Scott Buchta, a strategist at Guggenheim Capital Markets in Chicago. "We could certainly approach late 2007 bid/ask levels if (yield) spreads continue to tighten."
Trading volume is a variable that could help cushion profits from a drop in bid/ask levels. Tighter trading spreads should encourage volume, a dealer said.
Tighter trading spreads are not a given. Despite improvements, there are illiquid corners to bond markets as dealers remain in "discovery mode" Broadpoint's Certo said.
Jason Brady, a money manager at Thornburg Investment Management, a $40 billion money manager in Santa Fe, New Mexico, is finding dealers are offering incrementally better markets each day, but they still fall short of a year ago. Part of the reason is credit markets, while improved, are still far from heralding the end of the crisis, he said.
"You may not be able to wrangle the best bid/ask spread as you used to," he said.
"The other side, is given the poor pay conditions for sellside firms, there's an explosion of secondary trading shops out there. There is a broader array of folks searching for buyers and it's tightening up," he added.
(Editing by Jan Paschal)
