Chris discusses three essential areas to establishing and maintaining effective and productive broker-dealer relationships. He also shares a free resource to help manage your broker-dealer due diligence efforts.
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Hi there, welcome to Bond Investment Mentor! I'm your host, Chris Nelson, and this is a podcast dedicated to helping community financial institutions master the art of fixed-income investments. If you're working for a community bank or credit union, and you have responsibilities for the investment portfolio, you've come to the right place. I'll be your personal investment guide as we help you boost your fixed-income investment knowledge, level up your portfolio management skills, and help you gain the know-how you need to help your institution achieve its financial goals.
In this episode, we're going to talk about broker-dealer relationships. Over the years, this is one topic that I'm often asked about. And today, I'm going to answer the three questions I get asked the most. And I'm also going to share with you a new resource I've created to help you when it comes to new and existing bond broker relationships. Ready to go? Then let's get started!
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Hey, there, welcome back to Bond Investment Mentor! I know, I've been on a bit of a hiatus, right? You know you're in trouble when you start receiving emails saying, "Are you okay?," especially with what's been going on over the last year, you know, and I guess the final straw for me was a client who recently said to me, "I've listened to every one of your podcast episodes. You really need to get another one out." So, I decided it was time to get back behind the microphone again.
So where have I been? The truth is, I've been busy working with my investment advisory and mentoring clients, which are always a priority for me. And I've also been involved in several webinars and virtual conferences, I spoke for the Financial Managers Society, Darling Consulting Group, the Federal Home Loan Bank of Boston, and participated earlier this year in the Graduate School of Banking at Colorado's Community Bank Investments School. I'm also preparing for another upcoming teaching engagement, and I'll have some more to tell you about that in just a few minutes. And in addition to all of that, I've also been working on a couple of projects that I can't tell you a lot about yet, but I'll be able to tell you more about soon. So more to come on that. But it's just good to be back behind the microphone again to spend some time with you talking all things bonds and investments.
In this episode, we're going to cover broker-dealer relationships. And whenever I'm working with clients, or if I'm on the road teaching or training, this has always been a popular topic. I'm going to touch on three aspects of working with broker-dealers, as well as share a new due diligence resource that I think will help you evaluate new and existing broker relationships.
But before we get to that, I have a couple of other things that I'd like to cover today. We'll talk about reviewing the latest mortgage security prepayment data that came in for the month and discuss some key factors that could play a role in the Federal Reserve's decision-making process for tapering asset purchases, which is a big interest point for a lot of people. And I want to tell you a little bit more about the banking school that I'm involved with.
The July prepayment report for mortgage-backed securities came out recently and the report showed a slight increase in prepayment speeds this month, July, versus June. Overall, prepayment speeds rose by about 5-6%, or between one and two CPR for those of you keeping score. The increase in overall prepayment speeds was driven primarily by a one-day increase in the day count for the month, along with a slight decrease in mortgage rates of about an eighth of a point which resulted in marginally higher refi activity.
If you dig into the data, Ginnie Mae bonds continued to prepay faster than Fannie and Freddie paper, which has been an ongoing problem for some time. And I don't think that's going to change anytime soon. If we break the results down by term, both 20- and 30-year mortgage securities had an average increase of about one CPR last month when compared to the June report, with the average 20-year prepayment speed at 19 CPR, and the average 30-year prepayment speed around 22 CPR. 15-year bonds showed an increase in prepayments of about one and a half to two CPR for an average speed of about 18 CPR. So that's kind of how it looked across the spectrum.
As we look ahead, it's going to be interesting to see how prepayment speeds change in the coming months. With mortgage rates now at their lowest levels since February of this year, it definitely opens the door to a potential increase in refinancing activity. I read a recent Bloomberg report that explained that with the recent pullback in mortgage rates, another $250 billion in 30-year mortgages are now in a position to potentially consider refinancing. So we're going to have to wait a little bit and see how that plays out. We'll likely see prepayments for this period show up in the next month or so to see if that trend makes any changes.
The other thing over the past few months has been the debate about the Federal Reserve and how they might proceed with monetary policy as the economy reopens and we gradually move past the pandemic. investors have spent a lot of time scrutinizing the minutes to the FOMC meetings and the Fed's Beige Book reports. And of course, we can't forget the recent appearances by Fed chair Jay Powell on Capitol Hill.
In talking with clients, a question that I received recently concerns when the Fed might begin hiking short-term interest rates again. And this is also the focus of investors who are analyzing the Fed's dot plot as well as Fed Funds future market movements. But before the FOMC takes steps to begin raising rates again, they've made it very clear that they will begin tapering their asset purchases first, which have been running at about $120 billion per month in Treasuries and mortgage securities since the COVID outbreak in early 2020.
Former New York President Bill Dudley recently wrote an article that provided some perspective on how the Fed might proceed on that front. He suggested that labor market data would provide the best indication as to what the FOMC's timetable might be. While Dudley acknowledged the tightness in the labor market over the past few months, he attributed some of it to three temporary factors. They included a reduction in the labor workforce due to older people retiring, either permanently or temporarily, the effect of enhanced unemployment benefits that have been in place this year, and the effect of school closures forcing parents to stay home with their children.
Dudley commented that many of these factors would begin to pull back in September as schools reopen and the enhanced unemployment benefits expire. His expectation is that the FOMC will likely wait until the economic data providing information on these trends is released. Given that, Dudley does not anticipate any announcements about the timing of tapering until November or thereabouts. In the meantime, I guess we'll just have to live with volatile markets and yield curves.
There are a couple of other factors to consider as well. In a recent report, economist Chris Lowe commented that there is potential for major turnover among the Federal Reserve Board of Governors in the coming months. These include Fed chair Jay Powell, who's up for reappointment in February of next year, Vice Chair Randall Quarles, whose term ends this October, and Vice Chair Richard Clarida, whose term expires in January 2022. In addition, there is also an empty seat on the Federal Reserve Board that President Biden could nominate someone for. Depending on how the situation shakes out, it could have an impact on Fed monetary policy and decision-making regarding the tapering timetable.
On top of that, we'll have some additional changes on the Federal Open Market Committee come January. Each year, four of the committee seats rotate between the various Federal Reserve regional bank presidents. Currently, the Fed presidents from Atlanta, Chicago, Richmond, and San Francisco are voting members on the FOMC. In January, this group changes. The Fed presidents from Boston, Cleveland, Kansas City, and St. Louis will take their place on the FOMC, bringing their perspectives to the table more directly as voting members. So there's a lot that could happen in terms of the Federal Reserve's committee makeup and how the Fed proceeds with its monetary policy and decision making. As always more to come.
As I mentioned earlier, I'm going to be traveling soon for a teaching engagement. The Graduate School of Banking at Colorado's annual program began this week, and I'll be working with students in the coming week to help them learn more about managing the investment portfolio.
This is the graduate school's 70th year. Their annual program is a 25-month graduate banking curriculum made up of three annual two-week sessions in late July, along with research projects between those sessions. The aim of the program is to provide comprehensive industry training to help deepen community bankers' understanding of the industry. In addition, students have an opportunity to network with others from all over the country from the community banking world.
The annual program had to be canceled last year due to the COVID pandemic but this year, good news! The school is offering both in-person and virtual learning options. And there are about 400 students attending this year. The Graduate School of Banking at Colorado also offers other programs besides their annual flagship school session. These include the Community Bank Investments School, the Executive Development Institute for Community Bankers, and other workshops and webinars throughout the year. GSBC is always coming up with new programs and offerings to meet its objective of helping community bankers strengthen their knowledge and improve their skills. I'm looking forward to my upcoming teaching engagement and having a chance to work with community bankers again in person. If you'd like to learn more about the Graduate School of Banking at Colorado and its programs, you can head over to BondInvestmentMentor.com/Colorado for more information. I'll also leave a link in the show notes. And if you're attending, I look forward to seeing you there!
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Today, I wanted to cover a topic that I have been asked about frequently by community bank and credit union portfolio managers over the years, and that is the subject of broker-dealers. Generally, the questions I receive fall into one of three areas and I wanted to cover each of them here. The first question that I'm asked most frequently is, "How many broker relationships should a community financial institution have?" The short answer is that the number can vary, but I think it's important to have at least two brokers on board. Doing this helps on a couple of levels.
First, having more than one broker keeps things competitive, especially on the pricing front. When a broker knows that someone else is also involved, it keeps their pencil a little sharper with respect to their pricing. Working with multiple brokers also provides a little more transparency for you in terms of pricing indications for various bonds. You're going to be seeing pricing come from more than one direction and it just helps you to get a gauge as to what's going on in the markets. Additionally, working with more than one brokerage firm provide you with multiple perspectives, and that can be helpful as you shape your investment strategies.
The main thing to keep in mind when determining how many brokers you would like to have onboard is that the size of your portfolio and your trading activity will both play a role. You want to avoid stretching your trading volume over a larger number of brokers as you could end up spending too much time for too few trades. Having a lot of brokers also can limit your ability to build solid relationships. When managing the portfolio. It's better to have a few deeper broker relationships than a whole bunch of shallow and superficial ones.
The second topic that I receive questions about concerns broker due diligence. I want to share with you a few thoughts and areas on this to help you in your due diligence review efforts. First, you may want to consider taking a similar approach to what you use at your institution for other third-party vendors and your vendor review policies. It might be worth taking a little time to review those and determine which factors that are there could be helpful in assessing a new broker-dealer relationship.
In terms of what to include in a broker due diligence review, here are four areas that I think are worth considering. The first area would be to evaluate the financials and the background information for the brokerage firm itself. Your objective here should be to evaluate the financial stability of the firm. This information could include the brokerage firm's most recent annual report, their audited financials, and their most recent 10-K report if they are a publicly-traded entity.
You'll also want to request their most recent Focus report. This is a financial report that the brokerage is required to file on a regular basis with the regulators. In the report, you'll want to evaluate the firm's balance sheet as well as their computation of net capital and excess capital. And if the brokerage firm is part of a bank, it might be worthwhile to pull the bank's call report or UBPR to review the bank's overall health and position as well.
Finally, it's worth asking if the brokerage firm underwrites or issues securities themselves versus only offering so-called "street" bonds since each bond that a trader brings in from the street involves some sort of a price markup to you. Those brokerages that can originate their own paper can generally offer it at a slightly better price to you as an investor. It's also worth finding out how involved the brokerage firm is with the bond types in which you're interested. The higher the involvement, the better the analysis and the offerings might be.
The second area of your broker due diligence report would include background information on the broker that you're evaluating. A great resource here are the Broker Check reports that are offered by FINRA, which is the regulatory agency for brokers. These are available online, and they include information on the broker's work experience, their state licenses, which is important since you want to be sure the broker is licensed to work where you are located, and most importantly, any regulatory disclosures or findings for past violations or behavior. You can download a detailed broker check report by going to Brokercheck.finra.org. I'll leave a link in the show notes for you. In addition to the Broker Check report, it would be helpful if the broker can provide some form of resume to give you a better idea of their background and experience.
And then as you're talking with the broker, it would be great to understand what type of clients they work with. And more importantly, how many of them are banks or credit unions. It's helpful to know if the broker you're considering has experience working with the nuances and situations that are unique to community financial institutions. And then finally, it's worth asking if the broker would consider providing references of other clients similar to yourself. There's no guarantee that they'll have any available, but it's certainly worth making an inquiry about it.
A third area to check is the amount and quality of any research or resources that the broker can provide from their firm. Ask for a sample of recent reports or analyses so that you can get a feel for the firm's approach to fixed-income investing. In addition, you can check to see if you might have access to traders or analysts for occasional conversations and questions. Sometimes I have found spending a few minutes talking with a bond trader to be extremely helpful in trying to understand the markets and in developing investment strategies.
The last area of consideration involves other services that the brokerage firm might provide. These could include things like bond accounting, asset-liability management services, portfolio analytics, and training and education. One thing to keep in mind is that while the brokerage firm may offer many if not all of these services, you are under no obligation to use them. But it's nice to know what might be available if needed. Keep in mind that many of these services may have costs that can be indirectly offset through trading commissions. This is another reason why it's sometimes good not to spread yourself too thin with the brokers that you're working with. If you put together an evaluation and analysis covering these four areas, you should have a pretty robust due diligence report to help you in making a decision about whether or not to work with a prospective broker.
The last area in which I get questions usually revolves around managing the broker relationship once they're on board. In order to make your broker-dealer relationship work, it's important to make sure that the broker is doing what I call "working the inquiry" instead of just "slinging bonds." By investing in the time to let your brokers know where your interests lie and when you're investing, it will make for a more productive relationship for both of you.
Like any relationship communication is key. Let your broker know your communication preferences, whether it's by email, or phone, or both. Also, if you're not in the market at any given time, by all means, tell them. It's better to be upfront about it instead of ignoring all the emails and messages that might show up. In working with my brokers over the years, they've made it clear to me that they would rather know if an investor has stepped back from trading. It will make life easier for the broker too because in many cases, they don't want to be carpet bombing you with bond ideas if you're not interested, and it will make your inbox a little less cluttered.
When you're in the market, be open with your broker about telling them exactly what you need for your investment portfolio. And don't hesitate to tell them the questions, concerns, or things that you simply don't like about the bonds that are being shown. It helps them to better serve you. And they may challenge you on some things that can turn into learning experiences for you as an investor. Some of the best lessons I've learned about fixed-income investing came about as a result of these back and forth conversations with the brokers that I've worked with over the years.
You also want to make sure that you ask for what you need when you're evaluating investments. If you'd like to see certain Bloomberg screens in addition to what the broker provides, let them know. Or if there's a certain report or analysis you need, tell them. They're there to serve you and they should provide you with what you need to make a confident and informed investment decision.
And finally, the other question I get about existing broker relationships involves annual broker reviews. For many of you, this is something that your investment policy or your ALM policy requires you to do. To perform a good annual review, here are three steps I'd recommend. Step one, review past trading activity and volume. Have you had any trading settlement or other issues in working with the broker? If not, move on to step two, which is to refresh the firm's financials and update your Broker Check report. And after you've reviewed that information, the last step, step three, is to decide on whether you want to continue the relationship.
The overall objective for this process in evaluating new and existing broker-dealer relationships is to build and maintain strong and productive relationships with your broker that go beyond a simple investment transaction. By being proactive, your brokers can become a valuable resource as you manage your institution's investment portfolio.
Now to help you out with this process of evaluating new and existing broker relationships, I put something together for you. It's a broker due diligence checklist and it will help you to determine if a broker is a good fit for your institution's investment portfolio efforts. This checklist provides a step-by-step approach to evaluating a potential broker relationship. And it covers all the bases in terms of the information that you should be requesting, what we discussed earlier, to help you make a sound decision about working with a new broker. And you can also use the checklist for your annual reviews of existing broker relationships. If you're interested and would like to download a copy, go to BondInvestmentMentor.com/brokers and you can get a copy for yourself.
Well, I hope that you found the information today helpful. Thank you so much for stopping by! If you have any questions regarding anything that I covered today, or if you have any topics or areas that you'd like me to cover, please drop me a line at Chris @ BondInvestmentMentor.com. I'd love to catch up with you!
Also, if you haven't already, I'd like to invite you to subscribe to the podcast so you don't miss an episode. You can subscribe on any of the major platforms, or through whatever podcast app that you use. And if you like what you hear, would you please consider leaving a rating or review? It helps others discover and learn more about the podcast.
If you're looking for more information about fixed-income investing and portfolio management, check out the website, BondInvestmentMentor.com. You'll find articles, tips, and resources to help you manage your institution's investment portfolio. And you can also learn about the ways in which I can help you directly become better at what you do. And you can always connect with me on social media. on LinkedIn, I'm at ChristopherNelsonCFA, or on Facebook at Bond Investment Mentor. I'd love to hear from you!
Bond Investment Mentor is written and produced by me, Chris Nelson. The information, views, and opinions expressed during the podcast belong solely to me. And any ideas and strategies contained within the podcast are for educational and informational purposes only and do not constitute investment, accounting, or legal advice. I look forward to catching up with you again soon. Thanks for stopping by! Have a good one!
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