Fixed income continues to be Wall Street's primary engine of growth, but several realistic scenarios look bleak in the medium term. Market participants should be preparing for change now—modeling their total business exposure, preparing themselves for deteriorating conditions, and improving the structural health of the business mix and operating platform.

Five festive years

Fueled by low interest rates, US balances of consumer, corporate, and government debt have grown by 8 percent since 2000, while the economy has grown by only 3 percent. Mortgage-related issuance and high-yield lending have led the way, with 28 percent and 9 percent growth, respectively, during this period.

From 2000 to 2004, the fixed-income revenue of the top eight firms increased by 21 percent, while other sources of corporate and institutional revenue grew by only 1 percent. What's more, 2005 may turn out to be another record year for many firms, despite the turbulence that hit the collateralized-debt-obligation (CDO) market in the second quarter. For some firms, including Lehman Brothers and UBS, the increase in fixed-income earnings accounted for the majority of corporate earnings growth during this period.

Meanwhile, almost all firms have consciously increased fixed-income value at risk (VaR). Strategies among industry leaders differ. Strong mortgage businesses have enabled Bear Stearns and Lehman Brothers to increase their revenues much faster than their VaR. In contrast, growth of fixed-income revenues and VaR seems to have been more proportional for more diversified fixed-income market participants such as Deutsche Bank, Goldman Sachs, and UBS.

Glass half full or half empty?

The macro environment has achieved a precarious balance. In theory, both tightening by the US Federal Reserve Bank and deficit spending by the US government should put upward pressure on long-term rates. In practice, strong demand for US debt from net-saver countries, including Japan, Germany, and China, has been keeping rates low. This state of affairs may persist for some time, given the limited domestic investment opportunities for savings in many countries.

But the consumer- and corporate-credit environments are cause for concern. Total consumer indebtedness is at a historic high, with debt-to-asset ratios of 50 percent despite house price appreciation. Housing-related debt now accounts for four-fifths of consumer debt, as households borrow against their homes to fuel consumption (Exhibit 1). This housing-related debt is riskier than ever. Full-documentation jumbo mortgages fell from 75 percent of the collateral of private-label mortgage-backed securities in 2001 to 55 percent in 2004. Moreover, in 2004 more than 50 percent of jumbo mortgages in such structures were interest-only loans with adjustable rates. Above all, in 2006, 9 percent of outstanding mortgages will mature into a higher-rate environment (Exhibit 2).

On the corporate side, high-grade issuers have taken advantage of low rates to stock-pile cash. From 2002 to 2004, corporate borrowers used 70 percent of proceeds for refinancing—up from 47 percent from 1997 to 1999. By contrast, in the low-grade market, lending standards have declined dramatically. In April 2005 approximately 25 percent of US loan officers reported an easing of commercial lending standards—the highest level since 1990.

If and when the fixed-income market corrects and levels of issuance and indebtedness revert to the mean, market participants could face implications quite different from those of the past. Superior experience with credit market downturns will position the banks as natural leaders. Broker-dealers, given their high fixed-income VaR, will likely join banks in promoting market stability. It is more difficult to predict the behavior of other new and growing classes of asset holders—the real-estate investment trusts (REITs), hedge funds, and foreign investors—which are large players in the leveraged-loan and CDO markets and may have shorter investment horizons (raising capital to finance withdrawals, for instance).

Finding bearings

Given the importance of fixed income to the industry and the uncertainty about the market's future direction, we are considering the way the following five plausible scenarios could affect the economics of market leaders in fixed-income issuance and trading.

1. Noninflationary growth: real and nominal US growth continuing at recent levels, combined with a soft landing brought about by the gradual reduction in indebtedness of US consumers and corporations
2. Gradual recession: slower economic growth in the United States and other major markets, with declining incomes pushing marginal consumer and corporate borrowers into default
3. Broad-based repricing of dollar-denominated assets: weaker international demand for dollars, along with a slowdown and inflation in the United States, pushing up long-term interest rates and financing costs for US borrowers
4. Overburdened US consumers giving way: consumers too stretched—unable to sustain rising debt service levels as rates adjust upwardly
5. Corporate-liquidity crunch: "underdog" corporations, unable to maintain quality earnings in an intensely competitive environment, stumbling as rates adjust upwardly

Our early results suggest that the impact of some of these scenarios would be dramatic. In scenario 4, for example, return-on-equity levels in the subprime-mortgage industry could fall to 5 percent, from 20 percent now. Not surprisingly, we expect the prime-mortgage market to be much more resilient: in all five scenarios, the average industry ROE for prime mortgages, including the investment of profits, will probably stay above 10 percent. In all stress scenarios (2 through 5), the potential impact on total profits from mortgages is quite significant, with the softest correction resulting in a 20 percent decline from the baseline (Exhibit 3).

In the noninvestment-grade corporate-credit market, the current combination of loose deal terms, tight investment spreads, and new investors creates real concern about the volatility of spreads, if not the risk of outright default. In scenario 5, credit correction (in the form of a rapid widening of spreads) could be both swift and significant. In this gloomy scenario, the crossover names popular in many synthetic structures could transmit problems across investor types, while some hedge funds could force lower recovery rates. Scenarios 2 and 3, which are more likely, would put current spread levels at risk, since noninvestment-grade corporate borrowers would face heavy refinancing needs in an environment of higher rates. In any scenario, banks will again bear the brunt of the impact, as they continue to retain a significant portion of credit exposure. While the banks holding the majority of risky loans are well capitalized, a potential war on two fronts—corporate and mortgage—could prove very taxing.

Ready and able

Given the broad range of potential outcomes for fixed-income markets, this is no time for deterministic strategies. In fact, blindly following industry leaders to "close revenue gaps" in today's most attractive products is in all likelihood the best way to get caught in the wrong place when the market shifts dramatically.

The best managers of fixed-income issuance and trading businesses are already doing a few things well, among them:

• Anticipating changing market conditions. Standard risk modeling provides insights into expected events as predicted by recent, stable history. The best business-driven modeling takes a view of more fundamental changes in the market—for example, an inverted yield curve, a consumer collapse, or another Asian crisis—to test the resilience of a business and to anticipate the next big thing. Modeling should focus on timing as well as direction; bearing the opportunity costs of calling the top too early can be more painful than following the market down with everyone else.
• Integrating risk budgeting. Fixed-income business managers should have a Plan B ready in case market conditions change systemically. The plan should include triggers to cut back or increase risk exposure (market making and proprietary trading), more systematic portfolio-management strategies, and the rationalization of head counts. The best managers understand relationships among business lines and know how to respond to shifts in adjacent businesses as well as their own.
• Optimizing processes and systems. Industry leaders are investing today's excess profits in operational improvements, such as the integration of processing platforms within and across asset classes. Such improvements can help businesses weather challenging conditions; and more important, they will accelerate operating leverage when the market next turns up. Institutions that have already invested in integrated, multiasset-class trading and clearing systems and processes (Deutsche Bank, and Morgan Stanley, among others) will have much more flexibility and control than those still struggling to harmonize disjointed platforms.
• Reinventing the business system. Controlling origination through aquisition or exclusive purchase agreements has already become a "right to play" in many consumer-credit businesses. Further integration across origination and servicing—applying unusual approaches to data in order to change the game—can work as a macro hedge against interest rate risk. Some firms, for example, are already using these techniques to target at-risk customers for proactive refinancing solutions before higher rates push such customers into default.
• Building countercyclical businesses. Top firms are already investing in superior credit workout and owned-asset capabilities to get the maximum performance from their collateral under difficult circumstances. The best will either turn these capabilities into profitable third-party businesses (collections, special servicing) or use them to secure extraordinary profits from principal investments (nonperforming loans, distressed securities).