Examining Bond Portfolio Trends: First Quarter 2019
Beginning in May 2012 we started tracking portfolio trends of our bond accounting customers here at the Correspondent Division of CenterState Bank. At present, we account for over 140 client portfolios with a combined book value of $9.7 billion, or $66 million on average per portfolio. Twelve months earlier the average portfolio was $65 million. The lack of growth in average portfolio size over the past year speaks to the solid loan demand most banks have experienced during this time, and that has relegated investment portfolios to supporting roles in terms of operating importance.
For the ninth straight quarter yield behavior was characterized by curve flattening. The beginning of the quarter was marked by bearishness with the 10-year yield peaking at 2.79% on January 18. From that point forward, however, yields began a fitful decline as concerns over global growth, protracted trade negotiations, and the dovish turn by the Fed all weighed on market sentiment. The material drop in yields began in March as dovish Fed speak culminated in the extremely dovish March 20th FOMC rate decision that decisively paused rate hikes and downgraded both rate and economic forecasts. That led to 10-year yields falling to 2.37% on March 27th before ending the quarter at 2.41%.
Meanwhile, short-end yields also peaked on January 18th with the 2-year Treasury hitting 2.62% before also heading lower in fits and starts with the yield declines accelerating after the dovish March 20th FOMC rate decision. For the quarter, the two-year yield fell 23bps while the 10-year yield dipped 28bps. That action drove the 2yr-10yr Treasury spread from 19bps as the year began to 14bps as the first quarter ended. The 2yr-10yr curve flattening reached a low of 11bps on December 19th, the day of the last Fed rate hike. That spread represented an eleven and half-year low. With the Fed in pause mode it has allowed the short-end to rally, keeping the curve from flattening further towards inversion. If concerns over economic growth increase, however, that could cause a long-end rally pushing the curve towards inversion and all that that signals about recession risks. With that backdrop, lets look at how portfolio allocations and performance have changed over the past year.
Let’s begin by revisiting allocations a year ago, March 31, 2018, as shown in the pie chart to the immediate right. The MBS/CMO sector comprised 39.8% of portfolios, municipal allocations stood at 29.0% and Agency/Treasury investments were at 23.6%, a 1.5% increase from year-ago levels. Thus, the shift into municipal bonds that began in 2012 slowed to a standstill in 2017 and continued into 2018 as uncertainty over tax reform clouded the investment prospects for the sector.
Fast forward one year to March 31, 2019. The MBS/CMO sector comprised 38.8% of portfolios for a modest 1.0% decrease during the year as prepayments/maturities continued to be reinvested nearly dollar-for-dollar. Municipal allocations slipped to 26.6% (22.9% tax-free, 3.7% taxable) as the reduced corporate tax rate dimmed enthusiasm for the sector. Agency/Treasury investments picked up the slack in muni’s increasing from 23.6% a year ago to 25.9% at quarter-end. The “Other” category (corporates, CDs, and other floaters) increased from 7.6% to 8.7% as CD investments continued to be popular investments as portfolio managers searched for short-duration yield.
In summary, portfolio allocations continued a shift towards Agency/Treasury investments while muni’s saw modest outflows over the past twelve months. MBS/CMO allocations decreased 1.0% year-over-year but saw a slight uptick versus year-end. The “Other” category increased 1.1% as CDs remained popular with portfolio managers looking for yield with modest duration/price risk. The kneejerk decrease in muni allocations was perhaps understandable given the tax cut, but the sector still provides some of the best yields in the bank portfolio universe. The lack of a more dramatic change in allocation, however, indicates the moves were not so much strategic shifts in portfolio direction as they were modest changes in sector allocation. In fact, with most banks experiencing solid loan demand, investment portfolio management has been mostly on autopilot during the past year.
Now let’s look at portfolio performance trends. The graph below tracks average portfolio tax equivalent book yield, duration, unrealized gain/(loss) as a percent of book value, as well as 10-year Treasury yields and average portfolio size from March 2016 through March 2019.
As the above graph illustrates, tax equivalent book yields (red line) started reflecting the increase in market rates that prevailed through much of 2018 with a 19bps increase over the last year. The average book yield was 2.74% at quarter-end which represents a 7bps increase during the quarter and the highest yield since January 2016. With corporate tax cuts beginning in 2018, portfolios with moderate to heavy muni allocations saw tax-equivalent yields dip slightly in the first quarter of 2018 but that drop of approximately 5bps was reversed in the second quarter. The third quarter built on second quarter yield gains as higher market rates were reflected in higher portfolio yields, especially in the MBS category. The fourth quarter book yield held up well despite a 37bps drop in market yields during the quarter.
Looking at portfolio duration (orange line), the graph shows a decrease during the last three months dipping from 3.28 years in December to 3.17 years at quarter-end. Durations have trended lower over the past twelve months with the March 2018 duration at 3.66 years. As previously illustrated in the pie charts, portfolio allocations have changed only modestly in the past year so the decrease in duration during the quarter and year stems more from the decrease in market rates and subsequent increase in prepayment/call expectations given the lower rate environment. As shown, the 10-year Treasury began the quarter at 2.69% and finished the quarter at 2.41%. That 28bps decrease in yield during the quarter increased prepayment and call expectations and that contributed as much as anything to the modest drop in duration from 3.28 years at year-end to 3.17 at quarter-end.
Unrealized losses (blue line) improved during the quarter given the decrease in market rates during that time and the aforementioned decrease in portfolio duration. The year began with portfolios at an average unrealized loss of –1.88% of book value, a substantial improvement from the cycle low of –3.06% of book in the third quarter as market rates, driven by Fed rate hikes, inexorably increased through September 2018. Yields moved decidedly lower in November and December and after a brief uptick in February resumed the decline in March which allowed unrealized losses to improve again to –1.20% at quarter-end, the best level since December 2017.
Finally, new investments in the first quarter of 2019 focused on the MBS/CMO sector with 51% of total purchases (31% MBS, 20% CMO) and Agency/Treasury purchases totaling 29%. New muni purchases, however, were only 8% of new investments compared to 27% legacy muni allocations. The average tax equivalent book yield on first quarter 2019 purchases was 3.13% with an average effective duration of 2.94 years. In summary, first quarter 2019 purchases ($480 million in total par) were concentrated in the mortgage and Agency /Treasury sectors while purchased yields were 39bps more than existing portfolio averages. That yield advantage was also accomplished with slightly less price risk as the average duration on 2019 purchases was 2.94 years vs. 3.17 years on the existing portfolio average.
We will update this data again in July to track how allocations and performance characteristics are trending in 2019, a year that may represent something of a transition for the economy and hence for balance sheet management.
Thomas R. Fitzgerald
Director, Strategy & Research
400 Interstate North Parkway
Atlanta, GA 30339