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...