There are many great fixed income investment managers.

BlackRock runs the largest fixed income ETF with its $85.5 billion iShares Core US Aggregate Bond.

CalPERS is the largest manager of fixed income retirement plans with $141 billion under management.

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

The largest fixed income fund management group is PIMCO with $2.0 trillion under management.

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

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

Treasury and Fed MBS holdings represent 26.4% and 21.3% of the total outstanding debt in each asset class, respectively. This means that the Fed holds more than 1 in 4 government treasuries outstanding and more than 1 in 5 of all outstanding mortgage-backed securities. Talk about market dominance!

As can be seen from the graph, they recently increased their ownership. In 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 Treasuries and $1.2 trillion out of 2 $.0 trillion, or 60% of the increase in MBS.

Interestingly, the Treasury has a rule that in market auctions for the issuance of new debt, no bidder may buy more than 35% of the issuance to allow for wide distribution and create equity. However, this only concerns primary issues and the Fed makes all its purchases in the secondary market.

And all that demand for bonds is about to end!

The Fed announced in the minutes of its March 16 meeting^and FOMC meeting that they would soon begin reducing their balance sheet through securities liquidations. 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 Treasuries and $35 billion for MBS would be phased in over a three-month period, likely starting in May.

When fully implemented, the SOMA wallet will shrink by $95 billion per month, or $1.14 trillion on an annualized basis.

Implication for interest rates

This has been a tough year for bond investors as the Fed tries to fight inflation. Year-to-date through April 30, 2022, the Bloomberg Aggregate Bond Index returned -9.5%. April alone was the worst month, with a return of -3.8%.

Rates have risen across the yield curve and are the highest since the end of 2018. The yield on the benchmark 10-year Treasury note has risen 140 basis points year-to-date to 2. 91%, while the 2-year Treasury note rose the most at 2.73%, an increase of 199 basis points.

The Fed actually started reducing its bond purchases at the end of November 2021. It initially announced that it would reduce its monthly purchases from $120 billion to $105 billion, then at the end of December 2021 the monthly purchases were further reduced. reduced to $90 billion a month. As the red line in the chart above indicates, the Fed’s tapering coincided with the recent surge in the 10-year Treasury yield.

Now the Fed will completely stop buying as it begins to reduce its balance sheet.

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

At their next FOMC meeting on May 4^and, the Fed is expected to raise its target federal 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%. Further rate hikes are expected as the Fed estimates that the Fed Funds rate will reach 2.75% in 2023.

For longer maturities, rates are also expected to rise. The main buyer of Treasuries, the Fed, is now out of the market. It is unclear who will replace this request. Moreover, whoever they are, they will be more rate-sensitive investors than the Fed.

Currently, with inflation at 6.6% annualized and 10-year Treasury bills at 2.91%, the real return for investors is negative. In other words, the real return after inflation is -3.69% (2.91% -6.6%).

It’s not particularly attractive to value or income-oriented investors.

Implications for the balance sheet of the world’s largest bond portfolio

The rate hike 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’s Balance Sheet, the market value of the SOMA portfolio has fallen sharply. Currently, the declining market value of the SOMA wallet creates an estimated unrealized loss of -$440 billion. While Fed accounting allows the SOMA portfolio to be carried at amortized cost, the unrealized loss is huge. This is particularly acute in relation to the Fed’s capital of $41 billion. This is a tricky position for the Fed as it attempts to contain inflation.