Examining Bond Portfolio Trends: Second 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 $10.0 billion, or $64 million on average per portfolio. Twelve months earlier the average portfolio was $65 million. As has been the case for a few years now, the lack of growth in average portfolio size speaks to the solid loan demand most banks have experienced, and that has relegated investment portfolios to supporting roles in terms of operating importance.
The second quarter began on the heels of a very dovish March FOMC meeting that paused rate hikes and downgraded both the rate and economic forecast. That shift by the Fed helped break a string of nine straight quarters that were characterized by curve flattening. As the Fed moved to a “patient pause” approach as to rates the short-end rallied on the potential for rate cuts while the long-end remained range-bound over growth concerns and negligible inflation risks. That put a little steepness back into the curve.
As mentioned above, short-maturity Treasuries reacted to the shift by the Fed by rallying to year-to-date low yields as the prospects for rate cuts started to be priced into the market. During the second quarter, two-year yields fell 58bps ending June at 1.76%. Meanwhile, the 10-year yield dipped 40bps to 2.01% on the back of reduced growth and inflation prospects. That outperformance on the short-end of the curve drove the 2yr-10yr Treasury spread from 14bps as the quarter began to 25bps as the second quarter ended. With the Fed moving to an easing mode it has allowed the short-end to rally, keeping the curve from flattening further towards inversion. While the curve is still flat from an historical perspective, with the Fed moving to an easing stance it should keep the curve from inverting which will avoid the recessionary implications that inversion signals. 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, as shown in the pie chart to the immediate right. The MBS/CMO sector comprised 39.5% of portfolios, municipal allocations stood at 27.6% and Agency/Treasury investments were at 24.7%. The shift into municipal bonds that began in earnest in 2012 slowed to a standstill in 2017 as tax cuts loomed and outflows started in 2018 as tax reform-induced performance uncertainty clouded the investment prospects for the sector.
Fast forward one year to June 30, 2019. The MBS/CMO sector comprised 39.3% of portfolios for a negligible change during the past year as prepayments/maturities continued to be reinvested nearly dollar-for-dollar back into the sector. Municipal allocations slipped slightly from 27.6% to 27.2% (23.3% tax-free, 3.9% taxable) as the reduced enthusiasm for the sector after tax reform seemed to have mostly run its course. Agency/Treasury investments held their own during the year increasing slightly from 24.7% to 24.9% at quarter-end. The “Other” category (corporates, CDs, and other floaters) increased from 8.2% to 8.6% as CD investments continued to be popular with portfolio managers searching for short-duration yield.
In summary, portfolio allocations saw very little change during the past twelve months. MBS/CMO allocations decreased two-tenths of a percent year-over-year while the “Other” category increased four-tenths of a percent as CDs remain popular with portfolio managers looking for yield with modest duration/price risk. The kneejerk decrease in muni allocations we saw in 2018 was perhaps understandable given tax cut-driven headlines but the sector still provides some of the best tax equivalent yields in the bank portfolio universe. That fact seems to have helped stabilize the sector in 2019. In general, the lack of a more dramatic change in allocation, however, indicates the individual moves were not strategic shifts in portfolio direction. In fact, with most banks still experiencing solid loan demand, investment portfolio management continues to be mostly on autopilot just like last 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 June 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 15bps increase over the last year. As the quarter ended, however, the average book yield was 2.75% just 1bp more when the quarter began. The battle today is to maintain portfolio yields in the face of a 100bps drop in market rates that followed the November 2018 yield highs. In fact, average book yields have ranged between 2.71% and 2.75% this year as the drop in market rates has acted as a cap on book yields. While yields are not, as of yet, falling, the increases experienced last year have definitely stopped and now maintaining existing yield levels is the current challenge.
Looking at portfolio duration (orange line), the graph shows a decrease during the last three months dipping from 3.17 years in December to 2.94 years at quarter-end. Durations have trended lower over the past nine months with the September 2018 duration at 3.68 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 since November and subsequent increase in prepayment/call expectations given the lower rate environment. As shown, the 10-year Treasury began the quarter at 2.41% and finished June at 2.01%. Two-year yields dropped an even larger 58bps during the quarter and the decline in yields increased prepayment and call expectations and that contributed to the drop in duration from 3.17 years as the quarter began to 2.94 at quarter-end.
Unrealized gain/(loss) (blue line) improved during the quarter given the decrease in market rates and subsequent improvement in prices. The year began with portfolios at an average unrealized loss of –1.20% of book value, a substantial improvement from the cycle low of –3.06% of book in the third quarter of 2018 as market rates, driven by Fed rate hikes, inexorably increased through September 2018. Yields began moving lower in November and December and after a brief uptick in February resumed the decline more or less through June. Lower yields pushed prices higher allowing unrealized losses to improve again, this time to a slight gain of +0.16% of book value at quarter-end, the best level since August 2017.
Finally, new investments in the first half of 2019 focused on the MBS/CMO sector with 60% of total purchases (44% MBS, 16% CMO) while Agency/Treasury purchases totaled 19%. New muni purchases, however, were only 8% of new investments compared to 27% legacy muni allocations. The average tax equivalent book yield on first-half 2019 purchases was 3.09% with an average effective duration of 3.23 years. In summary, first-half 2019 purchases ($863 million in total par) were concentrated in the mortgage and Agency /Treasury sectors while purchased yields were 34bps more than existing portfolio averages. That yield advantage was accomplished with slightly more price risk as the average duration on 2019 purchases was 3.23 years vs. 2.94 years on the existing portfolio.
We will update this data again in October to track how allocations and performance characteristics are trending in the second half of 2019, and as we enter the Fed’s new rate-cutting cycle.
Thomas R. Fitzgerald
Director, Strategy & Research
400 Interstate North Parkway
Atlanta, GA 30339