Federated Hermes hosted its Q4'21 quarterly earnings call on Friday, which contained a number of comments on money fund fee waivers, swing pricing, rising rates and more. CEO Chris Donahue comments in his opening statement, "Now moving to money markets. Assets were up about $34 billion in the fourth quarter with about $20 billion from funds and $14 billion from separate accounts. In addition to seasonal trends, we benefited from ongoing stimulus-driven liquidity growth as well as wins in certain institutional market segments. Our money market mutual fund market share, including sub-advised funds was about 7.4% at the end of the year, up from 7.2% at the end of the third quarter. With the market pricing in a series of hikes in short-term rates in 2022, including the first increase in March, we have begun to see increases in the rates in the 3 months and longer portions of the money market curve. Tom will update how this impacts our yield waiver outlook."
He explains, "We believe that higher short-term rates will benefit money market funds beyond waiver relief. As in the 2009 to 2016 period of near zero rates, money market funds have retained most of their assets even as alternatives offered higher yields. Over the span of the last Fed tightening cycle that began in the fourth quarter of '16 through the last rate hike in the fourth quarter of '18, after an initial decline, our money market fund managed assets increased about 15%. The industry followed a similar pattern when after initial decline was followed by growth of 11% over that time frame."
Donahue says, "The higher rates helped us continue to grow these assets by an additional 22% through the third quarter of '19 when the Fed began to ease rates. Similarly, industry money market fund assets also grew in this period, showing a 14% increase. Now we closely monitor and comment on the SEC's proposed money market fund regulatory changes. The comments submitted to the SEC, by us and others, clearly note that swing pricing is not a workable alternative for institutional prime and muni money market funds. We believe that most institutions would not use these products if swing pricing were to be imposed."
He tells us, "In addition to uncertainty around redemption proceeds, large-scale system changes would be required by both money fund managers and investors to enable swing pricing to work. In our view, few, if any, will undertake these efforts. As a result, we expect that most of the assets currently in institutional prime and muni funds will shift to government money market funds, as many did the last round of changes in 2016, or to products like our private prime fund that are not subject to 2a-7 money market mutual fund regulations."
Donahue adds, "We have approximately $8 billion in client assets in institutional prime and muni funds that would be impacted if swing pricing were to be imposed as described. Taking a look now at recent asset totals. Managed assets were approximately $651 billion, including $436 billion in money markets, $90 billion in equities, $98 billion in fixed income, $23 billion in alternative private markets and $4 billion in multi-asset. Money market mutual fund assets were $294 billion."
CFO Tom Donahue says on the call, "Total revenue for the quarter was down 2% from the prior quarter due mainly to lower average equity assets, higher money market fund waivers, and lower performance fees, partially offset by higher money market assets, higher alternative private market assets and higher fixed income assets.... Advertising and promotional increased due to higher advertising and conference expense. We saw some restoration in travel and [with] short-term rates moving up in anticipation of Fed right Fed rate hikes beginning in March, we estimate that the negative impact on operating income from minimum yield waivers on money market funds for Q1 will improve to about $22 million compared to $38 million in Q4."
He states, "Assuming a Fed rate hike in March, we expect the Q2 negative impact to decrease about 90% from Q1 estimated levels. Estimates are based on our investment team's expectations for portfolio yields and recent asset levels, asset mix and other factors. The amount of minimum yield waivers and the impact on operating income will vary based on several factors, including, among others, interest rates, the capacity of distributors to absorb waivers asset levels and asset mix. Any changes in these factors can impact the amount of minimum yield waivers including in a material way."
During the Q&A, fee waivers were a big topic. Money Market CIO Deborah Cunningham responds, "Everybody's factors are a little bit different. It's asset levels, asset composition, how much is in government, how much is in Prime, how much is in Muni. The dynamics of the curves between those sectors, what the actual outlook would be on an expectation, whether it's additional moves beyond March, or only one or two moves throughout the year. You also have the expense factors that are being charged. Those are not uniform across the market. As such, the waivers aren't uniform based on those. So lots of different factors that go into that determination and calculation."
Asked more about swing pricing, Chris Donahue answers, "It deserves a draconian response. In Europe, they don't really do it on real money market funds, except that they're pricing them more or less out of a black box. What it does is you end up with pricing that makes the product unusable.... If 4% redemption occurs, then you have to go to a swing price. The customers aren't going to know that that's going on in a non-volatile time frame, and they're going to be surprised to the negative to get hit with what amounts to a redemption fee through the mechanism of a swung price."
He continues, "The mechanisms that have to be put in are expensive, time-consuming and of no value. And so why are customers going to do that? Why do we want to do it? Basically, it looks to me like it's ... what the Fed said years ago that they wanted to either kill prime and muni funds or regulate them out of existence. Our view is from a ... real stakeholder defense that issuers have the right issue in, and buyers have the right to buy, these products that have proven very resilient and very successful over the years, protestations by the Fed to the contrary, notwithstanding."
On rising rates and money fund flows, Cunningham says, "Historically, when interest rates have gone up, the initial reaction is for money market funds to lose assets. Generally speaking, over most cycles, it lasts longer than it did in the '16 to '18 cycle. We think this will be more like the '16 to '18 cycle.... Now it is dynamic, obviously.... Products reflect [rates now] from a yield curve standpoint faster than they have in [past] Fed tightening cycles. In this case, ... it's getting rates back to where they should be in a more normalized environment with an inflationary environment that also becomes more normalized."
Donahue responds, "Let me add also a couple of other factors. One is to take a look at the money supply. And all the money market fund [assets] is a function of that in the hands of all the individuals that have money, so this is a look at what you might call core money market funds, where people just need a cash management service. And this is an inexorable thing that grows. I don't think they're going to start shrinking the money supply. Now [that's] an underlying feature which enables us to get to higher highs and higher lows. It's one of the ingredients. Another one is these products over all these decades have shown tremendous resilience and tremendous ability to give the clients what they want. And so that's another big factor and why these products continue to be successful."
When asked about consolidation, Donahue answers, "What we have discovered is that the cycle really doesn't drive that truck. It's more of a longer-term internal decision by other potential roll-up candidates as the CEO and the businesspeople and the CFO of those enterprises decide whether those things make sense for them given the risk profile and the growth profile. So it just doesn't work as an accelerant. We've been in this a long, long time.... We simply call on them all the time so that when the opportunities arise, everybody knows that Federated Hermes is a warm and loving home for their money fund."
Finally, when asked about brokerage sweep balances, Cunningham tells us, "Well, first of all, those brokerage sweeps at this point are within our government sector. That's because of the FNAV nature of the prime institutional and municipal institutional that went into effect in 2016.... From an industry standpoint, I think about 20% to 25% of the government assets in the market, are in that type of a sweep arrangement."
President Raymond Hanley adds, "[C]oming out of the 2016 cycle ... as the rates rose, we did see exactly what you're talking about. The cash yields in and of themselves become -- it becomes a more attractive asset class.... [That] certainly, for us, helped us with brokers and other intermediaries who were able to ... move out of the default option ... with their cash. They're able to access meaningfully higher yields with us, and that was something we were very active in doing right up until the time where the Fed pretty aggressively moved the rates back down."
