Examining Bond Portfolio Trends: Third 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 139 client portfolios with a combined book value of $9.5billion, or $68 million on average per portfolio. Twelve months earlier the average portfolio size was $66 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 third quarter began with generally unchanged yields in July, but in August rates moved decisively lower following the Fed’s first rate cut in more than a decade on July 31st. That rate cut was characterized by the Fed as a “mid-cycle adjustment” which moved the 2yr-10yr Treasury curve back towards inversion as the 10yr Treasury rallied strongly on the belief the Fed might delay additional rate cuts until the economy showed more overt signs of slowing resulting in inadequate monetary easing by the Fed. Those concerns proved unfounded as the Fed followed its July rate cut with another in September and that prevented an inversion of the 2yr-10yr curve as the short-end followed the fed funds rate lower.
During the third quarter, two-year yields fell 13bps ending September at 1.62%. Meanwhile, the 10-year yield dipped 34bps to 1.67%. That outperformance by longer-term Treasuries flattened the 2yr-10yr Treasury spread from 25bps as the quarter began to 4bps at quarter-end. With the Fed moving to an easing mode, but not offering much guidance on future rate cuts, the long-end outperformed as investors sensed the Fed moving too cautiously to help a slowing economy and that long-end outperformance led to a near inverted curve as the third quarter ended. Some tentative good news in early October on the trade and Brexit fronts sent long-term yields rising and that kept the curve from inverting, but the yield back-ups have been modest as the geo-political uncertainties continue to overhang global growth prospects. 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 41.0% of portfolios, municipal allocations stood at 27.0%, Agency/Treasury investments were at 24.0% and the “Other” category (CDs, corporates and other floaters) was 7.90%.
Fast forward one year to September 30, 2019. The MBS/CMO sector comprised 39.2% of portfolios for a small decrease during the past year as prepayments/maturities continued to be reinvested almost dollar-for-dollar back into the sector. Municipal allocations rose from 27.0% to 28.5% (24.5% tax-free, 4.0% taxable) as the reduced enthusiasm for the sector after tax reform finally subsided and investors returned, lured back by still competitive tax-equivalent yields. Agency/Treasury investments mostly held their own during the year decreasing slightly from 24.0% to 23.7% at quarter-end. The “Other” category increased from 7.9% to 8.6% as CD investments continued to be popular with portfolio managers searching for short-duration yield.
In summary, as has been the case for some time, portfolio allocations saw very little change during the past twelve months. MBS/CMO allocations decreased 1.8% year-over-year while the “Other” category increased seven-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 understandable given tax cut-driven headlines but the sector’s still attractive tax equivalent yields proved too compelling and investors ventured tentatively back into the sector in 2019. As has been the case for a few years, the lack of a more dramatic change in allocation indicates individual moves are not strategic shifts in portfolio direction. Rather, with most banks still experiencing decent to solid loan demand, investment portfolio management continues to be mostly on auto-pilot with tactical moves dominating investment decisions.
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 September 2016 through September 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 as tax cut fever swept through equities and bonds. As 2019 began, however, 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 third quarter book yields peaked at 2.75% in June and finished September at 2.74%. Treasury yields continued to fall during the third quarter so the goal at present is to stabilize portfolio yields in the face of a 147bps drop in market rates since the October 2018 yield highs. While portfolio yields are not falling materially, as of yet, yield increases experienced in late 2018 have definitely plateaued and maintaining existing yield levels is the current challenge.
Looking at portfolio duration (orange line), the graph shows a decrease during the last nine months dipping from 3.28 years in December to 2.85 years at quarter-end. Durations have trended lower over the past year after peaking at 3.68 years in September 2018. 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 October 2018 and subsequent increase in prepayment/call expectations given the lower rate environment. That trend continued in the third quarter.
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 –1.86% 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 September. Lower yields pushed prices higher allowing unrealized gains to improve again, this time to +0.47% of book value at quarter-end,. The August level was even better at 0.86% when the 10-year Treasury yield pushed to a low of 1.50%.
Finally, new investments in the first nine months of 2019 focused on the MBS/CMO sector with 54% of total purchases (42% MBS, 12% CMO) while Agency/Treasury purchases totaled 24%. New muni purchases, however, were just 14% of new investments compared to 28.5% legacy muni allocations. The average tax equivalent book yield on the 2019 purchases was 2.80% with an average effective duration of 3.36 years. In summary, year-to-date 2019 purchases ($1.52 billion in total par) were concentrated in the mortgage and Agency /Treasury sectors while purchased yields were 6bps more than existing portfolio averages. That yield advantage was accomplished with slightly more price risk as the average duration on 2019 purchases was 3.36 years vs. 2.85 years on the existing portfolio.
We will update this data again in January to track how allocations and performance characteristics trended in 2019.
Thomas R. Fitzgerald
Director, Strategy & Research
400 Interstate North Parkway
Atlanta, GA 30339