When it comes to making money off cash sweep accounts, less can definitely add up to more in the eyes of analysts. While some financial services companies are getting credit upgrades for it (Advisor Group, Cetera), another is seeing its stock rating get lowered (Charles Schwab & Co.).
For the second time this year, Schwab’s stock target was downgraded by Bank of America, this time to $46 from $51, and it’s now down to half of the $92 per share target last seen in January. That’s when BofA first knocked Schwab stock down two notches from “buy” to “underperform,” skipping the “neutral” category altogether.
The primary reason for the drop was the outflows of client cash from high-margin sweep accounts. Suddenly, investors are no longer satisfied earning nominal interest on their cash sweep accounts when they could park those dollars in a money market account earning 4.5%.
Meanwhile, analysts at Moody’s Investors Service have upgraded the debt at Advisor Group Holdings and Cetera’s parent company, Aretec, in part because Moody’s expects them “to continue implementing a prudent strategy of increasing the portion of client cash swept into fixed-rate accounts and utilizing interest rate hedges to preserve the benefits of higher interest rates,” the analyst coverage stated.
The difference? “The main distinction with regard to cash sweeps and that revenue stream is that Charles Schwab operates a bank, whereas Advisor Group and Cetera do not. That leads to a few differences in how they monetize client cash,” said Gabriel Hack, the Moody’s analyst covering Advisor Group and Cetera.
Schwab’s cash sweep strategy, enabled by its own bank, yielded until recently an estimated 51% of its profits, all through interest income. It's important to note that while Schwab stock has been downgraded, its debt is still rated investment grade. Debt issued by Cetera and Advisor Group still carries a below investment-grade rating, even after the recent upgrades.
Because they don’t operate their own banks, however, Advisor Group and Cetera sweep client cash balances to third-party banks, where they’ve negotiated some fixed-rate hedges, Hack said. In addition, these brokerages serving wealth managers keep the lights on through advisory fees and commissions, and so they see nearly all of that incremental, high-margin revenue flow directly to their bottom line.
“We would expect that Advisor Group and Cetera are going to become much more profitable in 2023, and the bulk of that is going to be through growth of this client cash monetization,” Hack said. “It’s very high margin and flows mostly through to their profits.”
That doesn’t mean these broker-dealers will be completely impervious to the cash flight Schwab has suffered, however.
“Cash balances were elevated in 2022 for a lot of the financial sector, and given the higher interest rates now you will see some of that migrate, just like with Charles Schwab, to higher-yielding alternatives, like money market funds, and away from the sweep program where it can be monetized,” Hack continued. “However, there is a certain portion of those balances that are truly transactional in nature, and not yield seeking.”
For example, he said, investors need a certain amount of cash for paying bills and covering transactions day to day. This is reserve cash that was never intended to be invested at higher yields. This cash, Hack said, is rather sticky and will remain in those transactional cash sweep-eligible accounts.
Funding The No-Commission Trading Era
Fadi Massih, another Moody’s financial institutions analyst, also said Schwab was different because it has a large number of customers who are self-directed. “On average, the percent of cash out of total assets is higher than what you would see in an advisor channel, like AG and Cetera, where the percent of cash relative to client assets is much lower,” he said.
Problems for Schwab stock began in January when Bank of America downgraded the firm’s stock two notches and cut its price target to $75 from $92, reasoning that high yields on money market accounts would lure investors out of sweep accounts and equities.
This deprives Schwab of a major revenue stream that made the no-commission trading era possible. When interest rates were near zero, idle client cash stayed in sweep accounts. By one estimation, that net interest income accounted for 51% of the firm’s revenue in 2022.
Now that there are much higher paying money market funds for parking cash, customers want to move these assets to those higher-yielding accounts, which would dampen Schwab’s profits and force it to borrow money from the Federal Home Loan Bank to cover shortfalls while it waits for some of those more profitable investments to mature.
Moody’s analysts upgraded both Advisor Group’s and Aretec’s corporate family ratings to “B2” from “B3,” their senior secured bank credit facility ratings to “B1” from “B2,” and their senior unsecured ratings to “Caa1” from “Caa2.” Advisor Group’s senior secured rating was also upgraded to “B1” from “B2.”
At the same time, Moody's assigned a “B1” rating to Aretec's proposed $750 million senior secured term loan add-on and a “B1” rating to its $175 senior secured revolving credit facility due October 2024.
For both wealth managers, Moody’s changed its outlook to stable from positive.
Despite the upgrades, both firms remain below investment grade because their financial performance has not been as strong as some of their investment-grade peers, such as LPL. The key metrics for that evaluation are total profits, profitability, debt leverage and cash flow coverage, Hack said.
“Part of the reason for that is Advisor Group and Cetera are not public entities and are owned by a private equity sponsor. Given that governance structure, they carry a much more aggressive financial policy with regard to leverage and appetite for debt, and appetite for using debt to fund large acquisitions and maintaining high leverage in the normal course of business,” he said.