A Guide to the Nerds of Fixed Income (part 2)

Part 2 of my post profiling the relative nerdishness of various fixed income desks. Inherently, unapologetically biased. Anyone wishing to lodge complaints, corrections or additional context can find me at Jack Coombs Field watching Duke baseball in the super regional. #BlueCollar #GoDuke

Investment grade corporate credit

Eternally grouchy, but they have good reasons for being so. A universe of primarily plain vanilla bonds that trade as a spread product to treasuries due to the added default and liquidity risk. Trading volumes and liquidity measures are much lower, while financing costs are higher. The idiosyncratic credit risk make the bonds difficult to hedge, though the rise of exchange traded credit funds has made it easier to balance broad market-based credit risk. Wedged firmly between the debt and equity underwriting groups at big shops, the internal politics can be tricky. Practitioners are expected to know as much detail about the companies they cover as equity analysts, but are discouraged from disagreeing with their typical rah rah outlook. The infantry troops of fixed income - tough, hard working, nose to the grindstone, smart enough not to lift their heads when the bullets start flying. Can exhibit inspiring cohesion when cornered. Many years ago, during a particularly brutal comp and RIF season, a group of credit traders are rumored to have shown up to a 7am morning meeting already in the bag. Then proceeded to burp and pass gas throughout the meeting, while asking a few pointed but not impertinent questions. Absolute legends. 

High yield corporate credit

The smartest group on the floor next to the vol desk, leaning more towards law and accounting than quant. The market for high yield, or junk, rated debt is smaller, less liquid, significantly more complex and volatile than that of investment grade. Deep knowledge of bankruptcy and securities law, along with an exhaustive approach to analyzing financial statements, is standard. Often attracts lawyers and very sharp MBAs who can independently value balance sheet assets, and have niche expertise in the areas they cover, such as companies with biotech patents or mineral rights. Interest rate risk is trivial compared to the credit risk, which to the best of my limited knowledge is fairly unhedgeable. Similar to vol desks, books can blow up overnight, so steady nerves and deep appetites for risk are hallmarks. If they were slicker and more extroverted they would probably end up in investment banking or private equity. Intellectually sophisticated and fair minded, they are possibly the most interesting people to talk to over drinks. But don't cross them. They and their clients will bring a gun to a knife fight. 

Structured products

Beyond the $9 trillion agency MBS market, with trading volume of nearly $300 billion per day, lies the other structured product securities markets. These markets are smaller and relatively less, to extremely less, liquid and transparent. Understanding the asset class and its economic drivers, the characteristics of the underlying loans, and the interest rate and credit dynamics of the wide variety of securities that are structured from pools of such loans is hard work. A lot of specialized work that requires deep expertise in the business that produces the loans, e.g. subprime autos or commercial real estate; the financing and underwriting of the loans into securitization; and the structuring of cashflows from the pool into the various securities of the deal. 

For better and for worse, the temperament and personality characteristics of the various structured product desks tends to mimic those of people in the loan origination business. The upside is that the securities and the businesses they support can be complex and fascinating. The downside is that, although lumped together, they tend to operate within silos more so than other areas of fixed income because each market and product is so highly specialized. Pro tip: most structured products desks are bored silly listening to the other desks' market commentary in the morning meeting. The geeking out and jargon will make your eyes glaze over. 

Asset-backed securities (ABS)

If you cover or trade asset-backed securities based on autos, credit cards or student loans, it helps to have an interest in consumer finance and perhaps personal bankruptcy law. Most ABS matures in under 3 years, though some can go out to 5 years, so secondary trading tends to be very light and risk management is getting the deal out the door. The big swingers are on desks with large underwriting businesses, typically at bulge bracket financial institutions with broker dealers and commercial banks, though some smaller banks specialize in particular market segments and those desks can be outsized drivers of that business. People who work on ABS desks can glance at you, ask where you work, then rattle off a surprisingly prescient guess of your household income, credit score and the likelihood you will default on a loan. Esoteric ABS desks know weird stuff like what people keep in those self-storage sheds outside of Poughkeepsie and how much money different medical practices make. 

Commercial mortgage-backed securities (CMBS)

Well, tra la la. Here we are. There are two flavors of CMBS: 

• Agency CMBS, which is exclusively multifamily commercial real estate loans, guaranteed by one of the government agencies (Fannie Mae, Freddie Mac or Ginnie Mae). The better and chummier your relationship with the government agencies, the more deals you lead, more trading flow you can generate and clients you can bring to the table. Despite being closer to investment banking than is often comfortable, it's filled with people who are great team leaders, geeky enough to structure bespoke bonds and personable enough to sell them, and can navigate political relationships with the GSEs, the Fed and recently the FDIC. That is no small feat. Good drinking buddies all around. 
• The other flavor is non-agency CMBS and CRE CLOs, which are securities comprised of pools of stabilized and transitional commercial real estate loans, respectively, of any property type, e.g. multifamily, office, hospitality, industrial, etc. To lead CMBS deals you need a pipeline of loans and/or to provide financing to specialty lenders as loans are being pooled for a deal. If you don't lead at least the occasional deal, you are trading from the sidelines. Commercial real estate and the desks that traffic in it tend to be dominated by big deals and bigger egos. Donald Trump is not an outlier. The spectrum runs from charismatic, iconoclastic thinkers with high tolerance for risk to insecure dictators who can't abide anyone speaking out of turn, much less dissent. Watch your back. 

Closing remarks

I've been at a lot of sell side shops and worked on a variety of fixed income desks. A few things stand out to me that might be useful for people entering the business or considering a switch. 

• There is a big difference between broker dealers that are primary dealers for the Federal Reserve and everyone else. It has the biggest impact in treasuries, repo and agency MBS, but that flow and knowledge difference trickles down through other products as well. There are some clients, particularly some large international clients, who will not trade with a broker dealer that is not a primary dealer for the Fed. 
• Likewise, there is a considerable difference between shops that finance loans and are lead managers of deals or securitizations in an asset class, and those that are solely in the selling group on deals or trade strictly in the secondary market. More knowledge, more experience, greater ability and mandate to warehouse risk. Smaller desks may work harder for some client business and can be more discrete. 

A Guide to the Nerds of Fixed Income (part 1)

Years ago, when working at an unnamed European bank, I was attending a corporate retreat. During lunch one of my European colleagues jokingly but rather pointedly asked me, “why do you Americans think you are the center of the universe in finance?” 

Never known for my tact, I responded, “because we have the deepest, most liquid financial markets in the world. The US comprises about 40% of global debt and equity, which is 2 to 3 times the size of all European markets combined. Moreover, (yes, I really do speak like this and it’s as obnoxious as it sounds) about 25% of global trading volume across financial products is executed in NYC. So it’s not that we think we’re the center of the financial universe, it’s that we actually are.” 

Yeah I know, but they were French and traded equities. Two things I find baffling. I don’t inquire why France thinks it has the best wine or Paris believes it’s the cultural capital of the universe. It does, it is, and you’ll get no arguments from me. 

Size matters

The global fixed income market had $140 trillion of securities outstanding as of 2023, with US fixed income accounting for roughly 40%, or $55 trillion. That’s nearly twice the size of the EU and UK combined, which account for 23%. 

The global equity market is smaller at $115 trillion, but even more heavily weighted towards the US. The US equity markets represents 43%, or $49 trillion, while the EU comprises 11%; making US equities nearly 4 times the size of the next largest market. The third largest region is China, whose equity market cap is just under 10% of the global total. 

Bonds vs equities

A favorite quote of everyone in fixed income is from James Carville, a political strategist who rose to prominence during the Clinton years. 

“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.” 

If you work on the equity side of financial markets in virtually any capacity people tend to have at least a vague notion of what that is, and will politely suffer through a three minute response to the inevitable cold open of “what do you do for a living”? Those of us in fixed income have learned that responding at any length to such casual inquiries can result in a stampede to the bar as everyone within earshot suddenly needs to refresh their drink. 

The funny thing is that even within finance the two groups don’t tend to cross over much. It’s not just that they are functionally distinct markets, but the personalities of people who cover them are nearly diametrically opposed. 

The cheerleaders gravitate to equities

Equity markets are famously emotional. Yes, there are valuation models. Stock prices are supposedly tethered to reality via discounted cash flow models, price earnings ratios or other multiples, or some asset based method for estimating intrinsic value. Three different models will produce three wildly different theoretical valuations and none of them will be close to the actual stock price. The best laid battle plan rarely survives first contact with the enemy and the best stock price model can become irrelevant given a new company press release or government regulation. 

On the upside, every publicly traded share of stock of a company (of the same class) looks and is valued identically. Price, liquidity and trading volume data is mostly transparent and publicly available relatively quickly. There are nuances and dark pools and I’m sure loads of intricacies that I don’t know about or track because I’m not in equities. But overall I would say equity markets are easier to understand, particularly for non-experts, but can be more volatile and much harder to forecast. 

People who end up covering, trading, investing or underwriting equities tend to be optimistic, salesy, enthusiastic cheerleader types for their sector and the equity market in general. They tell good stories and they’re great fun at parties. 

The nerds are in fixed income

The bedrock of the fixed income universe is valuation models. These models project principal and interest cashflows, prepayments, delinquency and default rates, volatility and just about every nuance you can incorporate when valuing fixed income securities and derivatives. Practitioners spend an enormous amount of time and energy learning about, refining and evaluating them. 

The bond universe is also much more complex. Bonds from a single issuer will typically have a variety of coupons and maturities, and can occupy different places in the capital structure. Structured products, such as mortgage backed securities, asset backed securities and collateralized loan obligations, bundle loans into pools and structure the cash flows within an issue to create bonds with different interest rate and credit characteristics. 

The economic cycle, political shifts, global macro events and changes in investor sentiment impact trading and valuation in bonds as they do in stocks, but overall the impact tends to be more predictable and quantifiable. Disclosure of a CEO’s pending retirement or announcement of a new product launch, for example, might reverberate to the stock price but the company’s bonds are unlikely to register the event. 

Recognizing nerds in the wild

Many careers with a variety of specialties tend to sort based on personality type. Fixed income is no different. The following guide is based entirely on my subjective experience across sell side fixed income desks and my utterly biased opinions. Comments or additional color highly encouraged. 

Rates

May as well start with the adrenaline junkies. Treasuries, swaps and repo work closely together. They possibly have the broadest knowledge of markets and the Fed, deep appetites for risk, and if they execute basis trades for clients a pair of big brass ones. They don’t know a damn thing about credit but they don’t need to because everything they trade is either government guaranteed or fully collateralized on a mark to market basis. Not as sexy or complex as e.g. structured products, but the incredible pace, amount of risk taken and the size of their books can dwarf every other desk in fixed income. The biggest trades I’ve ever seen have been in treasuries and swaps, and they act like moving a few yards late on a Thursday is nothing. Intense, focused and surprisingly personable at work. Complete nutjobs off the clock. Someone is doing naked handstands at the rooftop bar? They work on the rates desk. 

Agency mortgage-backed securities (MBS)

More cerebral than rates but less dangerous than vol. Agency MBS is the second largest, most widely traded fixed income product after treasuries. It’s a flow product with functionally zero credit risk and is popular with investors worldwide. Broad based expertise similar to rates but with specialized focus on residential housing trends, prepayment risk, structured securities and mortgage derivatives. It’s a tricky combination of a deep, fast paced market in TBAs with the sophisticated knowledge and approach required to trade CMOs. MBS desks can be insular and clubby, as befits their reputation for reliably producing superstars. Intellectual, cool under pressure and quietly competitive AF. 

Volatility

Arguably the smartest desk in fixed income. Not always the most profitable. Heavily staffed by quants, these groups can produce wild P&L swings. As a vol trader once explained to me, “most traders are dating their risk. Vol traders are married to theirs, because they can’t usually get out of it.” Introverted and keenly sharp, they are appropriately wary of cowboy clients. Often at work the latest because their daily P&L isn’t calculated until all the vol and derivatives models have finished running. The MBS desk will be on their third Stoli O and soda before the vol desk badges out. Nerves of steel, an unassailable work ethic and a warped sense of humor are par for the course, because its not unheard of to walk into work to find that a trading book blew up overnight. 

That’s enough for today. Next episode will dissect the two sides of corporate credit, because investment grade and high yield have virtually nothing in common. And maybe I’ll profile the CMBS desk. Freaking hell. 

The Hill of Really Bad Takes That I Will Die On

• A perfect steak is tartare to medium rare. If you prefer it cooked beyond that, just order the chicken tenders. 

• Ebenezer Scrooge was deeply misunderstood. 

• Congress needs to pass legislation that will remove lawsuits requiring significantly complex scientific, medical or technical knowledge from adjudication at jury trials. There need to be specially educated and trained panels of judges who resolve these cases. See: Erin Brockovich and the crusade against PG&E, which was a public relations victory over both science and the law.

• The Outer Banks is as awful as Stranger Things is brilliant. 

This requires some context. The Pate brothers, who developed The Outer Banks, were born in my hometown of Winston-Salem, grew up in Raeford, North Carolina, and went to UNC Chapel Hill. Although it's likely they spent a lot of time vacationing on the Outer Banks, you would never guess it from watching the show. 

• Originally intended to be filmed in Wilmington (on the coast but considerably south of the actual Outer Banks) the location was hastily changed to the area around Kiawah and Charleston, SC, after the eastern NC redneck dominated state legislature passed that ridiculous "bathroom bill" in 2016. But when your show is titled and built around a geographically identifiable location (see: Yellowstone), using a stand-in diminishes the authenticity. In one episode, the intrepid gang visits a lighthouse, which looks entirely unlike any of the iconic OBX lighthouses. 

• The writing is lazy. The culture war depicted in the series between the Pogues and the Kooks is given no motivation beyond money and social status. The lead teenager role is a character named "John B", and his friends call him by name at least 5 times in every conversation. No one talks like that! I have no idea if it's a writers' tic or they were secretly trying to turn the show into a drinking game, but it's incredibly annoying. 
• The premise of the treasure hunt is fun and not as far-fetched as it seems. The area around the OBX is called the graveyard of the Atlantic. There are more than 2,000 known wrecks, with the earliest dating back to 1526. Blackbeard and his pirate crew spent years living in and around Beaufort, NC, on the southern end of the Outer Banks. The wreckage of his ship, the Queen Anne's revenge, was discovered outside of Beaufort Inlet, and rumors of his buried treasure have persisted for generations. There is so much history, legend, and real life ups and downs of barrier island life to explore and yet the writers seem to have all been holed up in LA with travel brochures. 
• I will charitably assume there was no actual wardrobe department, because it's jarring how bad the clothes are. 

• Bo Jackson was the greatest athlete of my generation and it's not even close. His highlight reels barely do him justice but they are still incredible to watch. Him running up the outfield wall remains one of my favorite clips of all time. 

• Though for spontaneous, bro athleticism, this is still one of the funniest videos I've seen. 

• Western North Carolina bar-b-que, with it's slightly sweet, tangy, tomato based sauce is far superior to vinegar-based Eastern North Carolina bar-b-que. That chorus of shotguns being racked is why this is by far the most controversial take on this list.