Examining Bond Portfolio Trends: Fourth 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 141 client portfolios with a combined book value of $10.03 billion, or $71 million on average per portfolio. Twelve months earlier the average portfolio size was also $71 million. As has been the case for a few years now the lack of growth in average portfolio size speaks more to solid loan demand and that has relegated investments to supporting roles in terms of operating importance.
Let’s begin by reviewing the rate environment during the fourth quarter. October opened with yields continuing a move lower that started after the September 18 FOMC meeting and the second of what ultimately would be three 25bps rate cuts for the year. Yields reached their 2019 lows during the first week of October as pessimism peaked that the Fed would be two-and-done with rate cuts, and thus fail to provide sufficient accommodation to a slowing economy. Some good news on the trade and Brexit fronts in early October sent long-term yields rising as the pessimistic economic outlook slowly eased, especially after several Fed officials signaled that additional rate cuts would be forthcoming if necessary, (which they delivered at the October 30 FOMC meeting). As the outlook for an additional rate cut increased, Treasury yields retraced the late September/early October rally. From mid-October, however, it’s been a range-bound market with yields varying only 15bps on the short-end, and 25bps on the long-end as both the outlook for GDP growth and inflation moderated.
During the quarter, two-year yields fell 5bps ending December at 1.57%. Meanwhile, 10-year yields rose 25bps to 1.92%. That outperformance by shorter-term Treasuries steepened the 2yr-10yr Treasury spread from 4bps as the quarter began to 34bps at quarter-end, which was also the high for the year. With the Fed cutting three times during the second half of the year, and exceeding expectations in some quarters, the short-end stayed closely tethered to the Fed’s rate cuts, while the long-end sold off a touch as optimism seeped into the market that the Fed would be able to engineer a soft-landing. 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 52.7% of portfolios, municipal allocations stood at 22.9%, Agency/Treasury investments were at 19.7% and the “Other” category (CDs, corporates and other floaters) was 4.7%.
Fast forward one year to December 30, 2019. The MBS/CMO sector comprised 55.5% of portfolios for a 3% increase during the past year as investors reinvested returning principal and then some, finding value in the sector as yield spreads to Treasuries widened, especially in the third quarter. Municipal allocations increased slightly from 22.9% to 23.9% (22% tax-free, 2% taxable) as the shock of lower tax equivalent yields from the 2018 tax cuts were slowly replaced with a grudging realization that muni’s still represent some of the best yields for a typical bank portfolio. Agency/Treasury investments dipped during the year decreasing from 19.7% to 16.6% at year-end as some called and matured bonds were reinvested elsewhere (most likely MBS) and not back into the sector. The “Other” category decreased slightly from 4.7% to 4.1% with CD investments constituting nearly half the category as they continue to be popular with portfolio managers searching for short-duration yield.
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 over the last two years.
As 2019 began, Treasury yields were dropping following the market volatility that characterized the fourth quarter of 2018. That drop in market yields finally started to show in portfolios as book yields peaked in the second quarter at 2.75% and finished December at 2.71%. Longer-term Treasury yields finally bottomed early in October with 10-year yields finishing December 25bps higher than when the quarter began. That modest move higher in Treasury yields occurred too late to alter the slightly softening trend in portfolio yields.
Looking at portfolio duration (orange line), the graph shows the year started with durations at 3.28 years and ended the year at that same level. Prior to December, durations were trending lower along with longer-term Treasury yields but the modest uptick in fourth quarter Treasury yields slowed prepayment and call expectations leading to the uptick in duration in December. As previously illustrated in the pie charts, portfolio allocations changed very little but with a slightly heavier MBS allocation and that may have contributed as well to the duration increase.
The year began with portfolios at an average unrealized loss of –1.86% of book value, but that unrealized loss represented a substantial improvement from the cycle low of –3.05% of book in the third quarter of 2018 as market rates, driven by Fed rate hikes, inexorably increased through September 2018. As 2019 began, yields were moving lower, and after a brief uptick in February resumed the decline more or less through September. Three Fed rate cuts and lower short-end yields pushed prices generally higher through the second-half of the year, including the fourth quarter, allowing unrealized gains to continue building, this time to +1.22% of book value at year-end. That print represents the highest unrealized gain since September 2016.
Finally, new investments for calendar year 2019 focused on the MBS/CMO sector with 58% of total purchases (49% MBS, 9% CMO), while Agency/Treasury purchases totaled 24%. New tax-free muni purchases, however, were just 12% of new investments compared to 22% legacy tax-free muni allocations. The average tax equivalent book yield on the 2019 purchases was 2.63% with an average effective duration of 3.76 years. In summary, 2019 purchases ($2.87 billion in total par) were concentrated in the mortgage and Agency/Treasury sectors while purchased yields were 8bps less than existing portfolio averages and durations about half a year longer.
Thomas R. Fitzgerald
Director, Strategy & Research
400 Interstate North Parkway
Atlanta, GA 30339