Examining Bond Portfolio Trends: First Quarter 2021

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 $14.3 billion, or $110 million on average per portfolio.  Twelve months earlier the average portfolio size was $77 million which represents a 43% year-over-year increase which speaks to softening loan demand during the year and the abundant liquidity that came aboard from the various stimulus programs. Portfolio size will likely continue to grow in the months ahead as the last stimulus program, passed in early March, works its way into bank balance sheets. After that, however, the improving economy should lead to growing loan portfolios and plateauing investment balances.


The fourth quarter trend of higher longer-term Treasury yields remained in place in the first quarter of 2021as investors saw a third stimulus package coming and improving vaccination rates pointing to greater growth, and inflation expectations, in 2021.  In fact, the impressive speed of vaccinations and resulting re-opening of many service-oriented segments of the economy are pulling forward growth expectations from a second-half 2021 story to a first and second quarter 2021 story.


With the Fed at the zero-lower bound on fed funds for another year or two, the short-end remains stuck in place. Meanwhile, longer-end yields rose for the second quarter in a row as optimism over a third stimulus package and positive vaccine news gave investors thoughts of strong growth and increasing risks of inflation. Illustrating the continued steepening behavior of the Treasury curve in the first quarter two-year yields rose 4bps ending March at 0.16%.  Meanwhile, 10-year yields rose 82 bps to 1.74%.  That price action steepened the  2yr-10yr Treasury spread from 79bps as the quarter began to 158bps at quarter-end, the steepest in nearly six years.  That steepness has mostly held in early April but long-end yields have been rangebound despite a string of exceptionally strong first-tier economic releases. Perhaps Treasury investors feel they have adequately priced in the pulling forward of demand into the first half of 2021 from the second half story that prevailed late last year. With that backdrop, let’s 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 below. The MBS/CMO sector comprised 55.1%  of portfolios,  municipal allocations stood at 25.6%, Agency/Treasury investments were at 15.2%  and the “Other” category (CDs, corporates and other floaters) was 4.1%.


Fast forward one year to March 31, 2021. The MBS/CMO sector comprised 60.9% of portfolios for a nearly 6% increase during the past year as portfolio managers continued to reinvest returning principal, and more, and moved more dollars to 30-year product to find acceptable yields.   This has been a trend for nearly a year now of increasing MBS allocations along with investing in longer duration pools in order to find decent yields. Municipal allocations decreased slightly from 25.6% to 24.3% (19.6% tax-free, 4.7% taxable). Valuations in the muni sector have moved into the rich range in the past year and that has perhaps slowed growth in the sector despite still offering some of the best tax equivalent yields for traditional bank investments. Agency/Treasury investments also dipped during the year decreasing from 15.2% to 11.2% at quarter-end as many called and matured bonds were reinvested elsewhere (most likely the MBS sector).  The “Other” category decreased slightly from 4.1% to 3.7% with corporate bonds constituting more than half the category at 2.6% while CDs totaled 1.1%, a decline from 1.3% in the prior quarter due to better yields elsewhere.



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.


The increase in longer-term yields that started in August 2020 continued into the first quarter of 2021 and it looks like the second quarter might bring even higher yields as the economy continues to improve.  Nevertheless, the extreme yield declines in the first few months of 2020 and resulting rangebound market into August were reflected in declining portfolio yields. 2020 began with portfolio yields averaging 2.71%, but by the end of the year yields had fallen to 1.98%, a full 73bps decline. During the first quarter of 2021 yields fell another 14bps to 1.84%.  As shown,  longer-term Treasury yields (green line) bottomed in August 2020 at 51bps and finished the year at 0.92%.  The increase in yields continued in the first quarter with the 10yr Treasury yield ending March at 1.74%. That increase in market yields should start to stabilize, if not increase, portfolio yields in the months ahead.

Looking at portfolio duration (orange line),  the graph shows 2020 started with durations at 3.28 years and ended the year at a nearly identical 3.32 years.   As Treasury yields moved decidedly higher in the fourth quarter of 2020 durations started to lengthen as higher long-term rates led to some slowing in prepayment and call expectations, as well as longer duration portfolio purchases, and that sent the average duration to 3.32 years from a low of 2.80 years in June. That, however, was merely a prelude to the first quarter of 2021 as continued long-end rate increases and longer duration purchases moved durations out to 4.28 years at quarter-end. That’s the longest duration we’ve had for the group since February 2014.

2021 began with portfolios at an average unrealized gain of 0.92% of book value. With rates continuing to rise throughout the quarter to yearly highs unrealized gains quickly dwindled to just 0.21% of book value as the quarter ended. Obviously, if market yields continue higher this quarter the unrealized gains that peaked at 3.07% of book in August will mostly likely be gone when we prepare the June 2021 report.

Finally, new investments in the first quarter of 2021 were once again dominated by the MBS/CMO sector with purchases equaling 62% of the $1.9billion in total par (58% in MBS and 4% in CMOs). The 62% MBS/CMO allocation compares to a legacy total of 61%. Of the purchases, 43% were in 30yr pools with 20yr pools at 31% and 15yr pools at 21%. The Treasury/agency sector followed with 22% of total purchases (12% callable, 8% Treasury and 2% agency bullet). That compares to a legacy total of 11%. The municipal sector followed at 12% of total purchases (7% tax-free, 5% taxable).  The 12% in muni purchases compares to 24% legacy muni allocations. The average tax equivalent book yield for the fourth quarter purchases was  1.39% with an average effective duration of 5.38 years.  Compare that to the legacy portfolio book yield of 1.84% and effective duration of 4.28 years. The trend towards longer duration MBS investments continued in the quarter as evidenced by the latest purchases. We will update this data again in July to track how allocations and performance characteristics are trending in the first half of 2021.

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Published: 04/08/21 Author: Thomas R. Fitzgerald