Guotai Junan Securities: Securities firms have expanded their fixed income trading for ten years. Differentiation and transformation are new themes.

Guotai Haitong released a research report stating that over the past ten years, securities firms' fixed income proprietary trading has expanded, gradually becoming a core business. However, in 2024, the industry as a whole began to shrink its balance sheet for the first time, returning to its roots. The report believes that the industry's transformation combined with the bull market in bonds has been the fundamental driving force behind the expansion of fixed-income proprietary trading in the past. From a business model perspective, the sources of profit for fixed-income proprietary trading include excess coupon income and capital gains, especially in a low financing cost environment. As a core business of the industry, fixed-income proprietary trading urgently needs to transform in the new era. The changes in a single business should be viewed as a facet of the industry's supply-side reform. During the transformation period, it is advisable to focus on certainty amidst uncertainty, and prioritize the top securities firms with significant comprehensive advantages and stronger cross-border asset allocation capabilities. Key points from Guotai Haitong: Starting from an observation: Securities firms' fixed-income proprietary trading has expanded over the past ten years and gradually become a core business, but in 2024, the industry as a whole began to shrink its balance sheet for the first time 1) Since 2014, securities firms' fixed-income proprietary trading has experienced a 32% annual growth rate, with the scale increasing from 180 billion to 4.4 trillion. Most securities firms have chosen to increase their proprietary trading in fixed-income securities, with a measurement based on the ratio of proprietary non-equity securities and their derivatives/net capital. In 2014, there were 2 and 1 firms at the 200% and 300% levels, respectively, but by the first half of 2024, these numbers had increased to 31 and 13 firms, showing a gradual annual improvement overall. 2) With the continuous expansion of scale, fixed-income proprietary trading has become a core business for securities firms. Taking CICC, First Capital, and Shanxi as examples, the profit contributions of their fixed-income business segments in the first half of 2024 were 40%, 48%, and 110% respectively. 3) However, by the end of 2024, the overall fixed-income investment scale of the industry had decreased by 1% compared to the previous year, marking the first year of balance sheet reduction. Returning to the roots, the report believes that the industry's transformation combined with the tailwind of a bull market in bonds has been the fundamental driving force behind the expansion of fixed-income proprietary trading in the past 1) Looking back at the ten-year expansion period of securities firms' fixed-income proprietary trading, it can be divided into two phases: from 2014 to 2017, the expansion was mainly driven by a significant short-term expansion of net capital, while from 2018 to the present, it has been driven by external bond market growth and internal demand for growth. To some extent, the expansion of fixed-income proprietary trading in the industry during the second phase has gradually shifted from a "passive" behavior to an "active" one - increasing fixed-income holdings has become one of the main drivers behind capital replenishment. 2) From a business model perspective, in a low financing cost environment, excess coupon income and capital gains are the sources of profit for fixed-income proprietary trading. In recent years, with rapid interest rate declines and credit spread narrowing, the proportion of rate bonds and OCI bonds held by securities firms has increased, leading to an expected increase in capital gains contribution to fixed-income revenue. 2025 marks the beginning of diverging development paths. Fixed-income proprietary trading remains an important component of top investment banks, but urgent exploration of new pathways for transformation is needed in the new era 1) Observing the trends in the 2024 annual reports of listed securities firms, it is observed that there is a more pronounced differentiation in their allocation of fixed-income proprietary trading than before. Among the 27 securities firms that have disclosed their annual reports, 9 of them have reduced their fixed-income proprietary trading, with top firms such as Huatai and Guosen seeing a 12% and 16% reduction in fixed-income investment scale at the end of 2024 compared to the previous year, while some small and medium-sized securities firms have seen reductions of over 50%. 2) Looking ahead, fixed-income proprietary trading may still be an important means for securities firms to improve capital utilization efficiency and a key component of building top investment banks. However, it is necessary to advance the transformation of fixed-income business in the new era, enhance strategic trading capabilities, explore cross-border asset allocation, and increase investment in client demand businesses as important directions for efforts by securities firms. Target recommendations It is recommended to prioritize top securities firms with significantly comprehensive advantages and strong cross-border asset allocation capabilities when looking for certainty amidst uncertainty. CITIC SEC (600030.SH), Huatai (601688.SH), and China Galaxy (601881.SH) are recommended. Risk warning Significant volatility in the bond market.