After the dot-com bubble and the events of September 11th, the Federal Reserve acted to stimulate the economy by dropping the overnight lending rate to a then unprecedented 0%. In the short term, that decision had the intended result of encouraging consumer lending activity and providing capital-intensive businesses stronger assurances to invest in equipment despite a weaker economic outlook. After the implosion of the financial markets in 2008 the Fed decided to apply the old “hair of the dog” remedy and has sustained historically low interest rates ever since. In August 2011 the Fed publicly pledged to maintain an overnight lending rate for banks between 0 and 0.25%, “at least through mid-2013.”
Extraordinary low rates have severe implications for markets. When the low rates were first introduced, I assumed that they would be relatively short lived and would not affect long-term investment decisions. However, with short-term rates stuck at 0%, bank deposits barely pay enough to finance the fuel necessary to travel to a bank branch, and money market funds are producing infinitesimal returns.
The recent move by S&P to downgrade the credit rating of U.S. debt has caused me to re-evaluate the Fed’s pledge regarding maintaining low rates. Now that the U.S. government’s rating has been downgraded, the Fed must somehow act to make U.S. debt more attractive to creditors. Ultimately, this must mean raising interest rate payments.
Commodity price inflation, caused by a falling dollar or otherwise, could also force the Fed’s hand into raising rates. Similarly, an unexpected expansion of the economy or a recovery in the jobs market would also allow the Fed to ease its easy money policy. Both of these seem far less likely than simply needing to continue attracting creditors by offering a mildly attractive rate.
Interest Rates as a Triple Catalyst
Management at the Goodhaven Fund (GOODX) recently offered this play on rising interest rates:
The underlying investment thesis is that rising rates act as a "triple catalyst." Not only will the company increase its profits from interest income, higher rates will also allow the company to redeem money market fee waivers, and a rising rate environment will drive growth in assets under management (because higher rates reward saving).
“Federated Investors (FII) is an investment management firm whose largest product category is money-market mutual funds and which manages more than $300 billion in total assets. The Donahue family, which started the business more than fifty years ago, continues to have a meaningful management and ownership interest. Despite being forced to offer large management fee waivers on money funds whose yields are close to zero, Federated continues to generate decent cash profits and high returns on invested capital. We believe that with a modest rise in interest rates, assets are likely to increase and a meaningful percentage of those waivers will be reclaimed and drop to the bottom line – demonstrating that the earnings power of the company is significantly higher than current results would indicate. While redemptions and unexpected regulations are always a risk, we believe the persistency of money market fund balances even at exceptionally low short-term interest rates is a testament to the strength of the company’s franchise.”
Shares of FII are being punished by the low-rate environment and by consecutive years of double digit declines in money market AUM, which are driving down EPS. Financial products are highly commoditized, and most investors probably don't even know who manages their money market accounts, so those lost accounts have little incentive to come back. The Fed has promised low rates for two more years and I don't want to get in early with a stock that has declining EPS and AUM while waiting for rates to rise. So where else can we apply this idea of an interest rate catalyst in a financial firm with a more broadly based revenue stream?
Question About Interest Rates? Talk to Chuck.
Interest rates will act as a triple catalyst and key driver of earnings growth for The Charles Schwab Corporation (SCHW), too. To reiterate, interest rates impact the company in three ways.
- Net interest margins,
- Money market fee waivers, and
- Assets under management.
SCHW has evolved from a trade commission driven online discount broker to a fee-based adviser where customers can bank online, trade options (recently completed acquisition of OXPS), and receive investment advice (“Talk to Chuck”). In theory, fees offer a more stable source of income than commissions on trades. Trade Commissions represent just 20% of the company’s overall revenue, compared with about 40% at competitors TD Ameritrade (AMTD) and E-Trade Financial (ETFC). The remaining 80% of SCHW’s revenue is fee based, with 35% from interest income and 45% from management fees.
SCHW has approximately $150 billion in money market funds compared with FII’s approximate $225 billion. Low rates mean fee waivers, and SCHW estimates that those waivers cost the company $150 million per quarter ($128 million in second quarter 2011 is the actual number). Those fee waivers are a large part of the reason the stock is down over 50% from its pre-recession highs and is re-visiting the lows set back in March of 2009.
Apart from the impact of low interest rates and the variable of trade commissions, SCHW was pressured into raising capital in January of 2010 after the YieldPlus Fund, an ultra-short bond fund, blew up during the recession. The company recently settled a lawsuit suggesting they misled investors about the risks associated with the fund. Hopefully management learned its lesson the first time and will be more prudent with new fund and ETF launches going forward.
Stocks don’t lose half of their value in three years because things are looking on the bright side. Taking that into consideration I believe the company has made prudent strides. SCHW is less reliant on trade commissions than its closest competitors, continues to safely pay its dividend from FCF, and hopefully has learned its lesson from the collapse of YieldPlus and will not repeat that mistake.
The most direct way for traders to play the interest rate game is to short treasury bonds (TBT). This approach is much higher risk than either FII or SCHW because of the higher margin expense of maintaining a short position and covering the yield of the bond while waiting for your investment thesis to play out.
Two other very high quality companies that I considered are Automatic Data Processing (ADP) and Paychex (PAYX). Both are levered to the jobs market and have only the single catalyst of increased interest income from rising rates. Triple-A rated ADP is one of the premier U.S. companies and a sound investment on its own merits but will not benefit from a rising rate environment to the full extent of FII and SCHW.
FII and SCHW offer a triple catalyst in the event of rising interest rates. Both stand to realize substantial improvements in revenue growth given even a modest increase in the Fed fund's rate. A return to the historic norm for short-term rates of 3% would represent a vast increase in profits at both firms. Both companies are family built institutions that have remained profitable throughout the downturn. Both firms trade near their respective 2009 lows. Finally, both offer investors willing to wait for a return to normal/historic interest rates a compelling investment opportunity. SCHW, as a retail broker, has a more broadly diversified revenue base than investment management firm FII. As such, SCHW is the more conservative investment choice of the two.
"More" recession or a low interest rate environment persisting beyond 2015 would render my investment thesis moot. Given the two-year window of low rates promised by the Fed, investors should have ample time to conduct due diligence.