Large IBDs more likely to feel cash sweep pain: Moody's

With large banks and wirehouses making increases to the interest rates they pay on clients' cash holdings in advisory accounts, it's the large independent broker-dealer and registered investment advisor networks, think Osaic Holdings, Cetera Financial Group, and Kestra, that may have the most difficulty keeping up with the competition due to fewer revenue streams and debt they carry, according to a new analysis by Moody's.

Facing potential scrutiny from regulators and increased competition from a number of firms, Wells Fargo & Co., bank of America Corp. and Morgan Stanley last month said they would be raising rates they pay clients in cash advisory accounts to bring yields more in line with money market accounts, according to the Moody's report, which was published last week and is titled: "Rising attention on cash sweep programs is credit negative for wealth managers."

Those moves by three wirehouses - with a combined total of more than 45,000 financial advisors of various stripes - set off a mid-summer cyclone for stocks of broker-dealers. By August 5, the NYSE ARCA Broker Dealers index, with the ticker .XBD, was trading at a recent low of $584, a decline of almost 13% from a recent high in July. The group has recovered, and Tuesday afternoon, .XBD was trading near $660.

Broker-dealers are particularly interest rate sensitive companies; they generate income from spreads on customer cash and margin loans to clients. Ever since interest rates began rising in 2022 post the Covid-19 pandemic, wealth management firms have faced questions about low interest rates they continued to pay clients on cash deposits, which can typically make up between 2% and 5% of a client’s overall portfolio.

Private equity managers use debt - and lots of it - to buy broker-dealers and RIAs.

"All the big firms have more cash in their sweep programs than they do in debt right now," said one senior industry executive, who spoke confidentially to InvestmentNews about the cash sweep issue. "But, those firms could get hurt twice: by paying out more in interest to keep up with the competition and a reduction this year in the Fed Funds rate, which means less yields on cash for the firms to pocket. Those will both hurt an IBD much more than help."

Spokespeople for Osaic, Cetera and Kestra did not return calls on Tuesday to comment. Osaic has 11,600 financial advisors in its network, with $653 billion in assets; Cetera, which is owned by Aretec, has 12,100 advisors and $521 billion in assets; and Kestra has 1,700 advisors and $117 billion in assets. All have been busy the past few years making significant acquisitions.

Diverse firms like the wirehouses are in better shape to weather an interest rate storm, according to Moody's.

"Firms with stronger finances and more diversified businesses have the flexibility to competitively shift client rates," according to Moody's. "Wealth managers operate across a wide range of corporate structures and financial strategies. Private equity-owned firms like Cetera/Aretec, Osaic and Kestra have less diverse revenue flows and aggressive financial policies, including operating with significant debt leverage."

Moody's rates the debt of Aretec Group Inc. and Osaic Holdings B2/Stable, or "junk," and Kestra Advisor Services holdings A Inc. B3/Stable, also "junk."

"Highly leveraged wealth managers face the greatest competitive risk from an increase in rates paid to clients and a corresponding decline in revenue," according to Moody's. "Wealth managers regularly review and compare their rates paid to clients with what competitors are offering, and any moves by larger firms to shift to more favorable client rates will likely drive similar shifts across the industry, posing particular risk for highly leveraged firms."

"Investment-grade publicly traded companies like Charles Schwab and Raymond James have more conservative leverage appetites and more diverse revenue sources, and therefore rely less on high-margin cash sweep revenue to service their debt," Moody's noted. "Wealth management businesses at “wirehouse” firms like Morgan Stanley and Wells Fargo are part of much larger groups with many other business lines, making cash sweep revenue a much lower portion of overall revenue and profit."