Examining Bond Portfolio Trends: First Quarter 2022
Examining Bond Portfolio Trends: First Quarter 2022
Beginning in May 2012, we started tracking portfolio trends of our bond accounting customers here at the Correspondent Division of SouthState Bank. At present, we account for over 130 client portfolios with a combined book value of $12.9 billion (not including SouthState Bank), or $99 million on average per portfolio. Twelve months earlier, the average portfolio size was $72 million which represents a 38% year-over-year increase which speaks to the soft loan demand and abundant liquidity that came aboard from the various pandemic stimulus programs. Portfolio size is very likely to plateau, if not shrink, in the months ahead as loan demand improves and excess liquidity starts to moderate.
The third and fourth quarters mostly tested yield ranges with a low yield of 1.17% in the 10yr (Aug. 3rd) and a high of 1.70% (Oct 21). December, however, did provide some contrast. The first half of the month saw yields dip to a low of 1.34%, but after the December FOMC meeting, and a new hawkish tone from the Fed, yields rose slowly to finish the year at 1.51%. The first quarter of 2022 saw that trend continue but with much more momentum and new yield highs for the pandemic period were set.
The hawkish tone of the December FOMC meeting was embellished and sharpened at the January and March meetings with the Fed beginning the first of what are likely to be many more rate hikes. The expectation now is the Fed will hike in 50bps increments and likely end 2022 close to 2.50%. That is, at least, what the market is pricing in for now. Also, the March minutes revealed the Fed would move quickly to reduce its balance sheet, perhaps as early as May with the expectation of taking the balance sheet down from nearly $9 trillion to around $5 trillion in three or so years. This quick pivot to full-on tightening mode led to record losses in bond prices during the quarter as Treasury investors repriced yields higher across the curve to reflect the revised scenario on rate hikes and rapid balance sheet reduction. Typical bank investments suffered a double-blow during the quarter. First, there was spread widening on almost all non-Treasury investments combined with duration extension owing to the higher rate/slower prepayment scenario.
During the quarter, two-year yields rose an astounding 161bps ending the quarter at 2.34%. Meanwhile, 10-year yields rose 83bps during the quarter to 2.34%. That price action flattened the 2yr-10yr Treasury spread from 77bps as the quarter began to 0bps at quarter-end. As mentioned above, that flattening action came as the Fed revealed it will move aggressively to combat inflation leading to higher short-term yields. Longer-term yields trended higher but were more range-bound believing the Fed would manage to quell the inflationary forces and also slow the economy as well. Now let’s turn our attention to the changes in portfolio allocation during the past year.
Changes in Portfolio Allocations
Let’s begin by revisiting allocations a year ago as shown in the pie chart to the immediate right. The MBS/CMO sector comprised 60.9% of portfolios, municipal allocations stood at 24.3%, Agency/Treasury investments were at 11.2% and the “Other” category (CDs, corporates and other floaters) was 3.7%.
Fast forward one year to March 31, 2022. The MBS/CMO sector comprised 58.3% of portfolios, a 2.5% decrease during the past year. This stops a trend that had been in place for over a year now of increasing MBS allocations, along with investing in longer duration pools in order to find decent yields.
Municipal allocations continued to decrease from 24.3% (19.6% tax-free, 4.7% taxable) last quarter to 20.9% (14.9% tax-free, 6.0% taxable). Prices in the municipal sector were rich over the past year and that has slowed growth in the sector, despite offering some of the best tax-equivalent yields for traditional bank investments. Prices held up early in the quarter but finally succumbed like most fixed income securities and the sector suffered significant price declines in March. The new, higher yields may entice investors to allocate more investment dollars into the sector in the coming months.
The Agency/Treasury sector was the one area that saw a definite increase during the year growing from 11.2% to 15.5% at quarter-end. The “Other” category decreased from 3.7% to 2.8% with corporate bonds constituting more than half the category at 2.2% while CDs totaled 0.6%, a similar level to the prior two quarters.
Changes in Portfolio Performance
Now let’s look at portfolio performance trends. The graph below tracks average portfolio tax-equivalent book yield, duration, and unrealized gain/(loss) as a percent of book value. It also tracks 10-year Treasury yields and average portfolio size over the last two plus years.
During the first quarter of 2021, yields fell 14bps to 1.84%. The second quarter saw yields stabilize at 1.86%, but they slipped another 9 bps during the third quarter to 1.77% and saw a modest uptick to 1.79% as 2021 drew to a close. The first quarter of 2022, despite rising market rates, saw stable yields closing the quarter at 1.80%.
As shown, 10-year Treasury yields (green line) began 2021 at 0.92%, increasing to 1.74% by March 31, the year-to-date high. In the second quarter, yields fell to 1.47% but were range-bound in the third quarter, ending nearly unchanged at 1.49%. This range-bound behavior continued in the fourth quarter with the 10-year yield finishing 2021 at 1.51%. The fireworks, however, erupted in the first quarter as inflation fever and a newly hawkish Fed gripped markets. The 10yr yield finished the first quarter at 2.34%, an increase of 83bps during the quarter and that continued into April.
In the first quarter of 2021 long-end rates increased and longer duration purchases moved durations out to 4.28 years at quarter-end. The second quarter, however, with its decline in longer-term Treasury yields, saw portfolio duration decline slightly from 4.28yrs to 4.25yrs. With range-bound yields in the third quarter durations drifted higher to 4.41 years as reinvestments in longer duration bonds continued. In the fourth quarter, durations were nearly unchanged at 4.39 years as market yields remained range-bound and portfolio mix changed very little during that time. This rather docile behavior in duration changed dramatically in the first quarter of 2022 as the aforementioned increases in market yields took hold and durations extended to 4.97 years. That’s the highest duration ever recorded in our data going back to 2012. The previous high was 4.84yrs in August 2013 coming on the heels of the infamous taper tantrum.
10-year Treasury yields were bitten hard by inflation fears and Fed rate-hiking threats in the first quarter and yields rose rather dramatically. The 10yr saw its yield increase 83bps during the quarter while shorter maturities had a tougher go of it with 5-year Treasury yields increasing 126bps. That had a significant detrimental impact to prices in that part of the curve. Unrealized losses reflected that difficulty, starting the quarter at –0.31% of book value but slipping to a new low of –5.40% at quarter-end.
Portfolio Purchases During the First Quarter 2022
Finally, new investments in the first quarter of 2022 were led by the Treasury/agency sector, dethroning the MBS/CMO sector which had typically been the leading sector over the past several years. The Treasury/agency sector purchases comprised 42% of the $2.0 billion in total purchases (33% Treasuries, 9% agency securities). The current Treasury/agency purchases at 42% easily exceeded the legacy total of 18%, so a definite shift in investments for the quarter. The MBS/CMO sector followed with purchases equaling 39% (30% in MBS and 9% in CMOs). These amounts were moderately less than the fourth quarter which comprised 45% of total purchases. The 39% MBS/CMO allocation compares to a legacy total of 58%. Of the MBS purchases, 36% were in 30yr pools, 28% in 20yr pools, and 30% in 15yr pools. The municipal sector followed at 10% of total purchases (8% tax-free, 2% taxable). The muni purchases compare to 21% legacy muni allocations.
The average tax-equivalent book yield for first quarter purchases was 1.86% versus 1.43% in the prior quarter. The average effective duration was 3.75 years versus 4.93 years in the prior quarter. Negative convexity was –0.42 versus –0.89 in the prior quarter. Compare those figures to the legacy portfolio book yield of 1.80% and effective duration of 4.97 years. For the first time in years portfolio managers added investments in the first quarter that exceeded the existing portfolio yield and with less duration than the legacy investments.
We will update this data again in July to track how allocations and performance characteristics trended through the first half of 2022.