Examining Bond Portfolio Trends: First 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 131 client portfolios with a combined book value of $10.09 billion, or $77 million on average per portfolio. Twelve months earlier the average portfolio size was $65 million. For the past several years there was little to no growth in average portfolio size due to solid loan demand. Thus, the modest increase noted in the first quarter perhaps speaks to a slight softening in that loan demand. Of course, that trend will be amplified in the months ahead as we grapple with the economic shock caused by the pandemic.
Obviously, the spreading pandemic dominated market action in the first quarter with the most volatile moves occurring in mid to late March as shelter-in-place orders became the norm for the country. Back in the halcyon days of January, yields were continuing a move lower that started in early 2019 but the move accelerated into quarter-end as the Fed instituted two emergency rate cuts that sent the fed funds rate from 1.50-1.75% to 0.00%-0.25% in the space of two weeks. Yields reached their all-time intra-day lows on March 9th. The 10-year traded as low as 0.30% on that day before closing at 0.54%. Yields remain near those month-end levels as we write this in mid-April. With the Fed at the zero-lower bound on fed funds, and the longer-end staring at most likely the deepest recession since the Great Depression, 0-handle yields across most of the yield curve are likely to be with us for this year and well into 2021.
During the quarter, two-year yields fell 132bps ending March at 0.25%, right on top of fed funds. Meanwhile, 10-year yields fell 125bps to 0.67%. That outperformance by shorter-term Treasuries bull-steepened the 2yr-10yr Treasury spread from 34bps as the quarter began to 42bps at quarter-end, the highest spread since mid-2018. With the recession just starting to be felt, yields are likely to be at these ultra-low levels, the only question is how quickly the economy can recover from the virus-induced blow. We believe it will be a fitful and slow recovery that is likely to keep the fed funds rate anchored at zero and longer-end Treasuries sporting 0-handle yields through this year and most likely into early 2021. 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 53.67% of portfolios, municipal allocations stood at 22.65%, Agency/Treasury investments were at 19.34% and the “Other” category (CDs, corporates and other floaters) was 4.33%.
Fast forward one year to March 31, 2020. The MBS/CMO sector comprised 55.13% of portfolios for a 1.5% increase during the past year as investors reinvested returning principal, and a tad more, finding value in the sector as yield spreads to Treasuries generally widened over the last twelve months. Municipal allocations increased from 22.65% to 25.64% (23.19% tax-free, 2.45% taxable) as the shock of lower tax equivalent yields from the 2018 tax cuts were slowly replaced with a 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 19.34% to 15.17% 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 decreased slightly from 4.33% to 4.06% 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 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 at 2.75% and finished December at 2.71%. Yields edged lower again in the first quarter dropping 3bps to 2.68%. 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 will continue to pressure portfolio yields lower as we move through 2020.
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 quarter 2020 durations eventually shortened with the quarter ending at 2.97 years. We expect the dramatic drop in yields to a new lower range will continue to pressure durations lower as prepayment and call expectations react accordingly, and that will force a shortening in portfolio duration.
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 2.68% at year-end 2019. In the first quarter, the reported unrealized gain dipped to 1.74% but that has more to do with when values were recorded in the last week of March when market volatility caused severe dislocations in pricing, particularly in the municipal sector. We expect the actual level of unrealized gains are better than the 2.68% of book that we saw at year-end and we’ll likely see that when April reports are run.
Finally, new investments in the first quarter focused on the Agency/Treasury sector with purchases totaling 41% of the $1.7 billion in total par (led by 20% in agency callable securities and 12% in agency bullets). The MBS/CMO sector followed with 37% of total purchases (34% MBS, 3% CMO). Nearly two-thirds of the mortgage purchases were in 30yr pools. Tax-free muni purchases totaled 14% of new investments compared to 23% legacy tax-free muni allocations. The average tax equivalent book yield for the first quarter purchases was 1.90% with an average effective duration of 2.98 years. We will update this data again in July to track how allocations and performance characteristics are trending in 2020.