Examining Bond Portfolio Trends: Third Quarter 2020
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 130 client portfolios with a combined book value of $11.5 billion, or $88 million on average per portfolio. Twelve months earlier the average portfolio size was $68 million. For the past several years there was little to no growth in average portfolio size due to solid loan demand. Thus, the increase noted in 2020 speaks to softening loan demand as the pandemic arrived on our shores in the first quarter. That trend of increasing portfolio size will likely continue in the months ahead as we grapple with the economic aftershocks caused by the virus.
The pandemic continued to dominate market action in the third quarter with the new yield ranges made in March and April mostly continuing to remain in place throughout the third quarter. While the second quarter was dreadful from an economic perspective, the third quarter saw the beginnings of a rebound in economic activity that kept yields from dropping further, but enough uncertainties remained that higher yields were tough to establish as well. With the Fed at the zero-lower bound on fed funds the short-end is essentially on a short leash. Longer-end yields are facing a little more volatility as talk of Stimulus 2.0 gathers renewed optimism. That will pressure long-end yields higher but with the economic realities still dominated by the course of the virus, those back-ups are likely to be limited.
Illustrating the range bound nature of the Treasury market in the third quarter, two-year yields fell 3bps ending September at 0.13%, right on top of fed funds. Meanwhile, 10-year yields rose 3 bps to 0.69%. That pricing action steepened the 2yr-10yr Treasury spread from 49bps as the quarter began to 55bps at quarter-end. With the economic recovery facing numerous headwinds, yields are likely to be at these ultra-low levels for awhile. We continue to believe it will be a fitful and slow recovery that is likely to keep the fed funds rate anchored at zero for several years, while longer-end Treasuries may see some limited upward pressure given talk of a new stimulus package, and of course, election-inspired volatility. 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 55.52% of portfolios, municipal allocations stood at 23.94%, Agency/Treasury investments were at 16.55% and the “Other” category (CDs, corporates and other floaters) was 4.07%.
Fast forward one year to September 30, 2020. The MBS/CMO sector comprised 56.77% of portfolios for a 1.25% increase during the past year as portfolio managers reinvested returning principal, and more, and moving more dollars towards 30-year product to find decent yields. Municipal allocations increased from 23.94% to 26.96% (22.8% tax-free, 4.2% taxable) as the shock of lower tax equivalent yields from the 2018 tax cuts were replaced with a gathering 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 16.55% to 11.60% at quarter-end as some called and matured bonds were reinvested elsewhere (most likely MBS and muni) and not back into the sector. The “Other” category increased slightly from 4.07% to 4.70% with corporate bonds constituting more than half the category at 2.70% while CDs totaled 1.9%.
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-plus 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 2019 at 2.75% and finished December at 2.71%. Yields edged lower again in the first quarter dropping 3bps to 2.68% but they really fell under the weight of the Fed’s zero lower bound policy following the pandemic hitting American shores with the book yield ending the second quarter at 2.39%, down 29bps. The drop continued in the third quarter with the yield finishing at 2.10%, another 29bps drop for the second consecutive quarter. That’s a 61bps drop in book yield during 2020. Taken against the average portfolio size of $88 million that’s more than $500,000 in reduced income. As shown, longer-term Treasury yields (green line) collapsed during the first quarter starting at 1.92% and finishing the quarter at 0.67%. That collapse in Treasury yields maintained in the third quarter with the 10-year yield holding at 0.69%. This will continue to pressure portfolio yields lower as we move through year-end.
Looking at portfolio duration (orange line), the graph shows 2019 started with durations at 3.28 years and ended the year at that same level. As Treasury yields moved decidedly lower during the first half of 2020 durations eventually shortened with the second quarter ending at 2.80 years and the third quarter a littler longer at 2.97 years as portfolio purchases in the quarter were decidedly of the longer duration type (more on that below).
2019 began with portfolios at an average unrealized loss of –1.86% of book value. With the Fed shifting to rate cuts in mid-year 2019, unrealized gains accelerated from 0.16% as of June 2019 to 1.22% at year-end 2019. In the first half of 2020 unrealized gains rose again ending June at 2.67% of book value. Unrealized gains finished the third quarter at 2.52% as Treasuries edged a bit higher in September.
Finally, new investments in the third quarter of 2020 focused on the MBS/CMO sector with purchases equaling 39% of the $1.3 billion in total par (35% in MBS and 4% in CMOs). The 39% MBS/CMO allocation compares to a legacy total of 57%. Of the purchases, 64% were in 30yr pools with 15yr pools at 25%. The Treasury/agency sector followed with 31% of total purchases (21% callable, 6% Treasury and 4% agency bullet). That compares to a legacy total of 11.6%. The municipal sector followed at 23% of total purchases (14% tax-free, 9% taxable). The 23% muni purchases compared to 27% legacy muni allocations. The average tax equivalent book yield for the third quarter purchases was 1.20% with an average effective duration of 4.56 years. Compare that to the legacy book yield of 2.10% and effective duration of 2.97 years. We will update this data again in January to track how allocations and performance characteristics ended 2020.
Thomas R. Fitzgerald
Director, Strategy & Research
400 Interstate North Parkway
Atlanta, GA 30339