Examining Bond Portfolio Trends: Second 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 $13.5 billion (not including SouthState Bank), or $104 million on average per portfolio.  Twelve months earlier, the average portfolio size was $79 million which represents a 32% year-over-year increase. This is in keeping with the last several quarters and speaks to the ongoing modest loan demand and  abundant liquidity that came aboard from the various pandemic stimulus programs. Average portfolio size peaked at $110 million in May so the plateau in portfolio size that we have been anticipating may have arrived. However, as the economy weakens, as is anticipated given the Fed’s rate-hiking campaign, portfolio size could very well grow again in the latter part of 2022 as loan demand once again softens.

The hawkish turn of tone at the December FOMC meeting has been heightened in the 2022 FOMC meetings with the Fed beginning the first rate hike with many more to come. The expectation now is the Fed will hike in 75bps or 100bps increments for the next couple meetings and end 2022 around 3.50% – 4.00%.  Also, quantitative tightening began in June and will increase over the next several months as balance sheet shrinking begins. It will take several years to return to something close to pre-pandemic size but it still adds to the removal of stimulus measures employed during the worst of the pandemic.  This quick pivot to aggressive tightening has led to record losses in bond prices this year as you will see in the next page. In addition to dramatically lower prices in general, typical bank investments suffered a double-blow. First, spread widening on almost all non-Treasury investments combined with duration extension owing to the higher rate/slower prepayment scenario contributed further to lower prices.

After rising an astounding 161bps in the first quarter, 2yr yields added another 58bps in the second quarter to 2.92%.  Meanwhile, 10-year yields rose 83bps during the first quarter and another 64bps in the second quarter to 2.98%.  That price action kept the 2yr-10yr Treasury very flat which varied from 0bps to 6bps 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 too but were more range-bound believing the Fed would manage to quell the inflationary forces but 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 below. The MBS/CMO sector comprised 60.7%  of portfolios,  municipal allocations stood at 22.5%, Agency/Treasury investments were at 13.5%  and the “Other” category (CDs, corporates and other floaters) was 3.3%.

Fast forward one year to June 30, 2022 shown below. The MBS/CMO sector comprised 56.7% of portfolios, a 4% decrease during the past year. This repeats the experience of the first quarter that reversed a trend that had been in place for over a year of increasing MBS allocations.

Municipal allocations continued to decrease from 22.5% (19.6% tax-free, 4.7% taxable) last quarter to 19.9% (13.9% tax-free, 6.0% taxable). Prices in the municipal sector were rich over the past year and that slowed growth, despite offering some of the best tax-equivalent yields for traditional bank investments. Prices finally succumbed this year like all fixed income securities and the sector suffered significant price declines in March and April. The new, higher yields are beginning to entice investors to allocate more investment dollars into the sector but it’s happening slowly.

The Agency/Treasury sector was the one area that saw a definite increase during the year growing from 13.5% to 20.7% at quarter-end. Much of that into Treasuries as investors took advantage of the much higher yields available in short to intermediate duration notes. The “Other” category decreased from 3.3% to 2.7% with corporate bonds constituting more than half the category at 2.2%.


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.


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 Second Quarter 2022

As 2021 drew to a close, portfolio yields ended the year at 1.79%. The first quarter of 2022 saw the first signs of higher market rates as portfolio yields rose 5bps to 1.84%. In the second quarter, yields continued to improve rising another 12bps to 1.96%. With plenty of typical bank investments on offer at 3% or better, we expect portfolio yields to continue higher in the months ahead.

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.

In the fourth quarter of last year durations were nearly unchanged from the prior quarter at 4.43 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 increase in market yields took hold and durations extended to 5.00 years. That was the highest duration ever recorded in our data going back to 2012, until of course, the second quarter of 2022. As market yields continued higher, so too did durations, peaking at 5.57 years in April and finishing the quarter 5.32 years. This nearly one year increase in duration during the first half of 2022 obviously had its impact on the significant unrealized losses logged during this time.

The increase in market rates combined with the aforementioned increase in portfolio duration had a detrimental impact to market values in all manner of fixed income securities. Unrealized losses started the quarter at –5.40% and ended the second quarter at a new all-time low for our records of –10.48% if book value.


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Published: 07/14/22 Author: Thomas R. Fitzgerald