Bond Portfolio Trends: Fourth Quarter 2022
Examining Bond Portfolio Trends: Fourth Quarter 2022
Beginning in May 2012, we started tracking portfolio trends of our bond accounting customers here at SouthState|DuncanWilliams. At present, we account for over 130 client portfolios with a combined book value of $13.96 billion (not including SouthState Bank), or $107 million on average per portfolio. Twelve months earlier, the average portfolio size was $99 million which represents an 8% year-over-year increase. This percentage increase has been trending down in 2022 as moderate loan demand continues and liquidity tightens. Average portfolio size peaked at $110 million in May. As the economy is projected to weaken in 2023, portfolio growth could accelerate as loan demand softens off the slowing economy.
The Fed’s hawkish tone has been a consistent theme through 2022 as the focus on inflation reduction has overridden the full employment mandate. The latest expectation is the Fed has 75bps of hikes remaining which will push the fed funds rate to 5.00% – 5.25%. However, the trend has been to adjust these terminal rate forecasts higher, but inflation is moving in the right direction so the latest estimate may be close to what eventually occurs. As you will see on the following page, the aggressive tightening in 2022 has led to record losses in bond portfolios.
The interest rate moves in 2022 were nothing if not monumental. 2yr yields added 370bps in 2022 to end the year at 4.43%. Meanwhile, 10-year yields rose 237bps to end 2022 at 3.88%. That price action kept the 2yr-10yr Treasury curve inverted throughout the fourth quarter ending December at -56bps. The inversion peaked at –84bps early in December and is the deepest since April 2000 as short rates rose with Fed rate-hiking projections. Longer-term yields trended higher too but were more range-bound believing the Fed would stem inflationary forces, and also slow the economy into recessionary territory. With that backdrop, let’s turn our attention to the changes in portfolio allocation during the past year.
Changes in Portfolio Allocations
Let’s begin our portfolio review by revisiting allocations a year ago as shown in the pie chart to the immediate right. The MBS/CMO sector comprised 59.4% of the portfolio, municipal allocations stood at 22.4%, Agency/Treasury investments were 15.5%, and the “Other” category (CDs, corporates and other floaters) was 2.7%.
Fast forward one year to December 31, 2022. The MBS/CMO sector now comprised 54.4% of the portfolio, a 5.0% decrease during the past year. This repeats the experience of the past three quarters of declining MBS allocations. Previously, MBS tended to lead new investments.
The decrease in municipal investments that has been a feature this year slowed in the third quarter and now has stabilized in the fourth quarter with allocations increasing, albeit slightly, from 19.5% (13.0% tax-free, 6.5% taxable) to 19.6% (13.1% tax-free, 6.5% taxable). By mid-year, higher yields and spreads began to entice investors to allocate investment dollars once again into the sector but the balance remains nearly 2.8% down from its year-ago level.
The Agency/Treasury sector has been the one area that has experienced increased allocations during the year growing from 15.5% to 22.4%. Much of that increase has gone into 0% risk-weighted Treasuries as investors took advantage of the much higher yields available in short to intermediate duration securities. The “Other” category increased from 2.7% to 3.6% with corporate bonds constituting more than 80% the category at 2.9%.
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 years.
As 2022 began, portfolio yields averaged 1.79% (red line). The first quarter of 2022 saw the first signs of higher market rates as portfolio yields rose 5bps to 1.84%. That trend continued throughout the year but the fourth quarter leveled off at 2.29% versus 2.31% in the third quarter. With market yields in most sectors at 4%, or higher, we expect portfolio yields will continue to lift in 2023.
As shown, 10-year Treasury yields (green line) finished 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 and that continued into the second quarter with the 10yr yield ending June at 3.02%, an increase of 68bps. The third quarter followed the trend finishing up another 81bps at 3.83%. The selling moderated some in the fourth quarter but yields still crept higher ending the year at 3.88%.
Durations began the year at 4.43 years (orange line). As you might expect, however, durations extended dramatically in 2022 off the increase in market rates. Durations finished the second quarter at 5.32 years (they peaked at 5.57 years in April). That was the highest duration ever recorded in our data going back to 2012. Durations during the second half of 2022 plateaued with the year-end level at 5.19 years.
The increase in market rates combined with the extended portfolio duration had a detrimental impact to market values for all fixed income securities throughout 2022. However, the bleeding paused in the fourth quarter with unrealized losses starting the quarter at –12.80% of book and ending the year slightly better at –11.77% (blue line).
Portfolio Purchases During the Fourth Quarter 2022
Finally, new investments in the fourth quarter of 2022 slowed from $984 million in the third quarter to $452 million, or $3.5 million for the average portfolio. These investments were led for the fourth quarter in a row by the Treasury/agency sector. That sector dethroned the MBS/CMO sector which had been the leading sector for the past several years. The Treasury/agency sector purchases comprised 66% of the $452 million in total purchases (36% Treasuries, 30% agency securities). The 66% Treasury/agency purchases exceeded the legacy total of 22%, so a definite shift in investments that began in the first quarter continued through the balance of 2022. The MBS/CMO sector followed with purchases equaling 17% (14% in MBS and 3% in CMOs). Compare these amounts to the fourth quarter of 2021 when MBS/CMO comprised 45% of total purchases and you can see the shift from MBS/CMO to the Treasury/agency sector. The 17% MBS/CMO allocation compares to a legacy total of 54%. Of the MBS purchases, 27% were in 15yr pools, 23% in 20yr pools, 22% in 30yr pools and 11% in 10yr pools. The municipal sector followed at 12% of total purchases (10% tax-free, 2% taxable). The 12% in muni purchases compares to a 20% legacy muni allocation.
The average tax-equivalent book yield for third quarter purchases was 4.61% versus 3.60% in the prior quarter. The average effective duration was 2.04 years versus 3.14 years in the prior quarter. Negative convexity was –0.25 versus –0.13 in the prior quarter. Compare those figures to the legacy portfolio book yield of 2.29% and effective duration of 5.19 years. With typical bank investments still on offer at yields 4%, or better, we expect continued improvement in portfolio yields with less duration risk during 2023.
We will update this data again in April to track how allocations and performance characteristics are trending at the beginning of 2023.
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