If you’re reading this, you probably don’t know too much about what you actually do in investment banking and sales & trading beyond a lot of work, Excel, and models and bottles.
We’re going to fix that today by teaching you all about Trading, what Traders actually do besides gambling and eating a lot of junk food, and specifically what you do in Fixed Income.
This was written by Jerry since he actually worked in trading before, so direct all questions/comments to him.
Types of Trading
“Trading” is a nebulous term, so let’s fix that by discussing the two basic types first: agency trading and prop (proprietary) trading.
There are far more than 2 types of trading, and there’s always overlap between these, but these are the basic categories.
Agency Trading: You simply execute orders for the client – you’re merely an “agent” doing what he/she wants and do not have (much) freedom.
Prop Trading: You are the principal and can make whatever trades you want, using your own money – within your trading mandate and risk limits.
These are the 2 extremes – no choice, and 100% choice. In between is a generic area termed flow trading where there’s some element of agency trading but also some prop trading involved.
Example: in flow trading if the client wants to buy a stock, you can be the seller – and if he wants to sell, you can be the buyer, so you’re effectively acting as the principal there.
Flow traders can also choose to reject orders and generally have more freedom than pure agency traders.
Note: There is a lot of discrepancy and overlap between all these different types of trading, and each firm is set up somewhat differently. These are just the basics.
Equities vs. Fixed Income vs. Everything Else
Flow trading and agency trading refer to whether or not you have clients. The other main category is what you trade – individual companies’ stocks? Bonds? Currencies? Derivatives of those?
There are lots of different groups within Sales & Trading at a bank, but today we’re going to focus on Fixed Income – anything that involves debt.
Originally, Fixed Income meant that whatever you traded had a “fixed” income stream – think bonds, loans, or anything else based on bonds or loans (derivatives). If it paid a certain interest rate and was redeemed at the end of a specified period, it was fixed income.
But once clever bankers started creating collateralized debt obligations (CDOs) and other fancy instruments that no one really understood, the term “Fixed Income” lost its meaning – all of those were placed into this category, even though nothing about them was “fixed” other than the potential to destroy the economy.
Prices of these securities are affected mostly by interest rates set by the Fed and by the credit quality of the corporate and government issuers.
FX and commodities traders work closely with those in Fixed Income and they are often classified in the same group, even though nothing about exchange rates or commodity prices is “fixed.”
Types of Fixed Income Trading
Groups are usually divided by the types of instruments you trade – whether they’re relatively “safe” government bonds, more risky corporate bonds, or even more exotic securities. Of course, occasionally traders will venture a bit out of their own turf to trade other instruments if it is allowed at their firm.
This includes US government debt (notes, bills, and bonds, known as US Treasuries), Euro-denominated German debt, and yen-denominated Japanese government bonds. There are also others like inflation-protected bonds, repurchase agreements, and bond futures.
Usually you only trade the government debt of one country, and if your team is big enough you might specialize in a certain area like 5-10 year bonds.
Although government bonds are “safer” than other fixed income securities, the job itself can be stressful because these markets are constantly trading – even in off-market hours. And that means that you need to follow these markets, even when you’re out of the office.
Since there’s so much liquidity, you can take huge positions without too much trouble (unlike, say, buying 20% of a company’s stock where you would have to disclose it). Traders who bet on the US lowering interest rates in 2008 made small fortunes by betting big.
The Work Itself
You spend most of your time as a junior trader predicting changes in the shape of the risk-free interest rate curve, because that is the #1 factor that impacts government bond prices.
There’s not too much valuation work; usually you just do simple DCF calculations in Excel or on Bloomberg to get prices – it’s not like investment banking or private equity where you use many different methodologies to value companies. Your main concern is DV01, or how much you make or lose for every 1 basis point move in interest rates.
If you like macroeconomics rather than analyzing individual companies, government bond trading may be good for you.
Corporate Bonds and Credit Default Swaps
Corporate bonds are just like government bonds, except companies issue them so there’s always the chance of default – and the yield is higher to compensate for that.
If you’re working with smaller or non-US/European companies, you need to watch the news constantly to stay on top of things – but compared to government bond trading there’s less emphasis on macroeconomic happenings.
Credit Default Swaps (CDS), meanwhile, are like insurance on bonds: they’re derivatives that let you separate the risk of default from the risk of interest rates falling, so you can effectively “insure” yourself against losing your investment.
Most banks combine these two groups, since the value of corporate bonds and credit default swaps are closely related.
The Work Itself
You spend most of your time analyzing the credit profiles of different entities and weighing the bond yield against the risk of default – so you follow both company-specific and macroeconomic news.
You analyze credit profiles by looking at the financial statements of a company, the sector as a whole, and companies’ credit ratings.
Some say the work is more “interesting” than government bond trading because you’re working with different companies and because there are more trade possibilities – buying one company’s stock while shorting competitors’, for example.
These days it would be tough to get a job in this division due to the financial crisis and the sheer number of credit teams that have been laid off.
CDS may become more “standardized” on an exchange, which might improve liquidity and transparency – so opportunities there may return in a few years.
Structured Credit Trading
Of the different Fixed Income groups here, Structured Credit Trading is the most different because they don’t spend all their time checking the market and keeping up to date on the news.
Instead, they price and package complex financial products in Excel and then sell them to investors.
They don’t make trades every day, but when a trade does happen it could be for an amount of hundreds of millions or billions of dollars – compared to the other two groups above, where the size of individual trades is typically much smaller.
Although Structured Credit Trading is the most “quantitative” of entry-level Fixed Income jobs, you don’t need a Math Ph.D. or anything because you don’t actually create the tools used to price complex securities – that’s for the Ph.D.-level quants. You just need to understand the tools and how to use them to create your own products.
You don’t spend much time looking at individual companies, since most of these “financial products” involve hundreds of companies.
The Work Itself
See above. You spend a lot of time in big Excel spreadsheets figuring out how to price different securities. This is more quantitative than what you do in investment banking or private equity – in those fields, you mostly just do addition and subtraction, and sometimes multiplication or division if it’s super-advanced.
Right now it would be very difficult to actually get into Structured Credit Trading because of the financial crisis – most groups have been hit hard, just like everything else related to credit.
However, in the long-term there will still be possibilities here, so it’s something to consider if you’re still a few years away from looking for internships or jobs.
So now you might be wondering, “Ok, so it sounds like a lot of this is repetitive and like you do a lot of grunt work as a junior trader – surely, the exit opportunities must be better, right?”
If you go into investment banking, you could go into a wide range of different fields afterward – private equity, hedge funds, venture capital, corporate development, or something completely different.
That’s because the skill set you develop is so specialized – valuing companies and performing due diligence is useful in a lot of different fields, but knowing how to trade CDOs would be completely useless at a startup or venture capital firm.
Typically, as you advance you become even more specialized – so if you start out trading corporate bonds for European telecom companies, chances are you will go to a hedge fund that also trades corporate bonds for European telecom companies. You get pigeonholed very quickly as you move to the buy-side, which is one reason I chose to leave and start my own firm instead.
That’s not to say that you can’t move into other fields in finance if you start out in trading – but it is very rare to see a full-time trader move into, say, private equity or consulting following several years on the trading desk.
Equity Trading, Day(s) in the Life of a Trader, and more…