The Largest Bond Portfolio In The World

Summary

• There are many large Fixed Income investment managers, but the largest bond portfolio in the world is the $8.7 trillion System Open Market Account (SOMA), managed by the Federal Reserve Bank.
• The Fed's SOMA portfolio is made up of $5.9 trillion of US Treasury securities and $2.7 trillion of Mortgage-Backed Securities.
• As the Fed reduces its balance sheet through runoffs, the main source of demand for fixed income securities is exiting the market and will be difficult to replace.

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There are a lot of large Fixed Income investment managers.

BlackRock manages the largest Fixed Income ETF with their iShares Core US Aggregate Bond at $85.5 billion.

CalPERS is the largest Fixed Income pension manager with $141 billion under management.

The Vanguard Total Bond Market Index Fund is the largest mutual fund at $298 billion.

The largest Fixed Income Fund Management group is PIMCO with $2.0 trillion under management.

Yet far and away, the largest bond portfolio in the world is the $8.7 trillion Systems Open Market Account (SOMA) managed by the Federal Reserve Bank.

Bloomberg and Federal Reserve

The Fed’s SOMA portfolio is made up of $5.9 trillion in US Treasury securities and $2.7 trillion in Mortgage-Backed Securities.

The Fed’s Treasury and MBS holdings represent 26.4 % and 21.3% of all outstanding debt in each asset class, respectively. This means that the Fed owns more than 1 out of 4 publicly outstanding Treasury bonds and more than 1 out of 5 of all outstanding Mortgage-Backed Securities. Talk about market dominance!

FRED & SIFMA

As can be seen from the chart, they have been increasing their ownership recently. During the past two years of the COVID pandemic the Fed has purchased $3.5 trillion out of $5.9 trillion, or 59% of the increase in Treasury securities and $1.2 trillion out of $2.0 trillion, or 60% of the increase in MBS.

Interestingly, the Treasury has a rule that during market auctions for issuance of new debt no bidder can buy more than 35% of the issue to allow broad distribution and create fairness. This, however, only pertains to primary issuance, and the Fed makes all of its purchases in the secondary market.

And all of this demand for bonds is about to end!

The Fed announced in the minutes to their March 16^th FOMC meeting that they would soon begin a reduction in their balance sheet through security runoffs. As bond proceeds are received by the Fed in the form of maturities or prepayments, they would only be reinvested subject to caps. They agreed that monthly caps of $60 billion for Treasury securities and $35 billion for MBS would be phased in over a period of three months likely starting in May.

Once fully implemented, the SOMA portfolio will decline by $95 billion per month, or $1.14 trillion annualized.

Implication for Interest Rates

This has been a tough year for bond investors as the Fed attempts to combat inflation. YTD through April 30, 2022, the Bloomberg Aggregate Bond Index has returned -9.5%. April alone was the worst month, returning -3.8%.

Rates have risen across the yield curve and are the highest they have been since late 2018. The yield on the benchmark 10-year Treasury note has risen by 140 basis points since the beginning of the year to 2.91%, while the 2-year Treasury note has risen the most to 2.73%, an increase of 199 basis points.

FRED

The Fed actually began tapering their bond purchases in late November 2021. They initially announced that they would reduce their monthly purchases from $120 billion to $105 billion, then in late December 2021 monthly purchases were reduced further to $90 billion per month. As indicated by the red line in the chart above, the Fed’s tapering coincided with the recent spike in the yield of the 10-year Treasury note.

Now the Fed will stop buying altogether as they begin the reduction of their balance sheet.

On the short end of the curve, rates will continue to rise as the Fed tightens to combat inflation. The recently released Personal Consumption Expenditure index (PCE), the Fed’s preferred measure of inflation, was 6.6% year over year in March, a 40-year high.

At their upcoming FOMC meeting on May 4^th, the Fed is expected to raise their target Fed Funds rate for the second time this year, this time by 50 basis points. The new Fed Funds target will be between 0.75% and 1%. Additional rate increases are expected as the Fed estimates the Fed Funds rate will hit 2.75% in 2023.

As for longer maturities, rates are also expected to rise. The major buyer of Treasury bonds, the Fed, is now out of the market. It is unclear who will replace this demand. Additionally, whoever it is, they will be more rate sensitive investors than the Fed.

Currently with inflation at 6.6% annualized and 10-year Treasury notes at 2.91%, the real yield to investors is negative. That is, the after inflation real return is -3.69% (2.91%-6.6%.)

This is not particularly attractive to value or income-oriented investors.

Balance Sheet Implications for the World’s Largest Bond Portfolio

The rise in rates this year has created another problem for the Fed’s SOMA portfolio. As discussed in my recent article, The Unspoken Impact of Inflation on the Fed Balance Sheet, the market value of the SOMA portfolio has fallen sharply. Currently, the decline in the market value of the SOMA portfolio is creating an unrealized loss of an estimated -$440 billion. While Fed accounting allows the SOMA portfolio to be carried at amortized cost, the unrealized loss is huge. This is particularly acute when compared to the Fed’s capital of $41 billion. It is an awkward position for the Fed to be in as they attempt to rein in inflation.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.