Give ne back my hat!

Bond price moves in opposite direction of yield. Have you ever

wondered how bond traders even make money? Here it is and I quoted.

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Short answer: the bond market is absolutely huge.  US government bonds alone account for tens of trillions in notional value. Furthermore, these are the most liquid, heavily traded, and closely watched securities in the world. As "riskless" assets, they play a fundamental role in economics and in asset allocation. With such a huge amount of bonds being traded, it's not surprising that there's a lot of money to be made in this market.

Longer answer: the bond market is huge. But size alone cannot explain profits. Bonds have several other features that make them a very profitable asset class: liquidity, macro-economic importance, quantitative tractability, fungibility of cashflows, essentiality to almost all portfolios, and simplicity. These features means that large profits can be generated in a number of different ways: buy-and-hold investing, arbitrage, commissions and market-making. I try to explain some of these in the rest of this answer.


There are essentially 4 types of participant in the bond market, with different roles, incentives and economics.

First, there's "real money". This group includes mutual funds, corporate treasurers, asset managers, pension funds, insurance firms, endowments, and some private investors: anyone who has cash that they need/want to invest in the bond market.  These investors are long-only; they don't go short and they don't use leverage. Typically, they're not interested in micro-variations in price or value; they are making large-scale, top-down asset allocation decisions. They buy and hold large notional amounts of bonds for long-ish periods of time.

These investors are paid fees that are a percentage of "assets under management".  Many of these investors have portfolios worth billions or tens of billions of dollars, so even 0.1% of AUM adds up to a lot of fees. 

Second, there's "prop traders" which includes hedge funds and internal prop desks at investment banks. These folks use leverage (a lot of it!); they go both long and short, using repo to finance their positions; they might layer on swaps, futures, options and other more complex derivatives on top of their basic bond positions. They may use different trading styles -- arbitrage and relative value, technical/behavioural, risk premium capture -- but essentially they are all trying to "beat the market" ie generate profits beyond the risk-free rate of return.

Prop traders are paid fees that are a percentage of profits generated -- usually, 10% to 20%, known as the "slope" or "carry". A good prop trader / desk can make anywhere between 10 million and 100 million in trading profits a year; a great one can make north of 100 million.  Prop trading desks can thus generate huge revenues for the banks or hedge funds that house them.

Real money and leveraged prop traders are usually grouped together as the "buy side". Ultimately, they're the customers in the bond market; without them, the market would not exist. But although the make up all the demand, they don't trade directly with each other. Instead, they trade using intermediaries; middlemen collectively known as the "sell side".  These middlemen make up our 3rd and 4th type of bond market participant.

The third type is the inter-dealer broker. These are companies that don't trade themselves; they never buy or sell or hold any bonds; nor do they have any capital to deploy in the market. Instead, they provide a "marketplace": an electronic screen where other people can display their offers for bonds they want to sell, or display their bids for bonds they want to buy. If party A lists a bond for sale at a particular price, and party B is willing to buy at that price, then the broker connects the two (anonymously so they don't know each other's identity) and takes a small fixed commission on the transaction.

Brokers are responsible for a huge amount of transaction volume -- 100s of billions of dollars in notional every day. Even though their commissions are tiny (fractions of a basis point), the net profit that they generate is vast -- and it's all riskless, since they never take positions of their own.

But what if a hedge fund or real money investor wants to sell a bond that nobody else wants to actively buy? Listing on a broker screen won't help in that case. Enter the fourth type of participant: the dealer aka the flow trader aka the market-maker. The key to being a dealer is holding "inventory" -- a supply of bonds (owned or borrowed) that can be used to take the opposing position to any buy-side trade request. A good flow trader anticipates which bonds will be in demand, and builds up a stockpile in those. She anticipates which bonds will be unwanted by the market, and builds up a short position (by borrowing). She then offers the former and bids the latter. Over the medium term, flow traders tend to have no net positions, so ultimately they too are merely matching external supply and demand; but they have some temporal flexibility in doing this. And they get richly compensated for providing this temporal smoothing.

A major-market flow trader can easily print billions of transactions per day; even if their market-making margin is just an eighth of a tick (the smallest price increment available for Treasuries), that's still millions of dollars a day in PL. In smaller markets, the transaction notionals are smaller but the bid-ask spreads are wider so the PL remains high. When I was trading, my typical single transaction would be for 50k to 100k in DV01 and I'd willingly pay 0.1 to 0.2bps to a dealer for execution; that works out to 5k to 20k in execution fees for every trade I did -- and I was just 1 out of 100s of clients.

When you read reports of a major Wall St bank making huge profits on bond trading, chances are it's from a combination of categories 2 and 4 above. Prop trading and flow trading.


(PS. I spent nearly a decade as a pretty successful prop trader for a large hedge fund specializing in bond arbitrage. My boss at the hedge fund worked at Salomon Arb in the 80s and 90s; he's featured by name in Liar's Poker. So I know a little bit about this space.)
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Permalink WorldRover 
April 19th, 2017 12:35pm
>>As of 2009, the size of the worldwide bond market (total debt outstanding) is an estimated at $82.2 trillion,[3] of which the size of the outstanding U.S. bond market debt was $31.2 trillion

https://en.wikipedia.org/wiki/Bond_market

Amazing that national debt is such a huge business.
Permalink Kenny the Robot 
April 19th, 2017 12:47pm
You don't trade bond as a small trader, not even wabi-sabi.

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Bonds typically trade in $1,000 increments and are priced as a percentage of par value (100%). Many bonds have minimums imposed by the bond or the dealer. Typical sizes offered are increments of $10,000. For broker/dealers, however, anything smaller than a $100,000 trade is viewed as an "odd lot".
Permalink WorldRover 
April 19th, 2017 12:54pm
>Amazing that national debt is such a huge business.

There was actually a concern, back in the Clinton days when we were fiscally responsible, that we were going to completely pay off the debt, and then what would be the riskless investment safe haven for the world.

But then the Electoral College.
Permalink Shylock 
April 19th, 2017 1:31pm
Electoral College?  It was the Supreme Court that decided the 2000 election, have you forgotten already?
Permalink SaveTheHubble 
April 19th, 2017 2:41pm
Gore got 500K more votes than W did. If we had a decent Constitution, the Hussein Family Regime would still be keeping Israel safe from Iran.
Permalink Shylock 
April 19th, 2017 3:55pm
Yes, you should totally amend US Constitution for the benefit of Israel.
Permalink Yoda 
April 21st, 2017 2:08am
Huh? I was just saying, in a backhand way, that a President Gore would never have invaded Iraq.

If anything, the EC is good for Israel, as Republicans are much more reliable supporters of Israel than Democrats are these days. It's the only good thing about them.

No, we need to abolish the EC for ourselves, not for anyone else.
Permalink Shylock 
April 21st, 2017 7:48am
Go for it.
Permalink Yoda 
April 21st, 2017 10:05am

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