Federated Hermes, the 6th largest manager of money funds, reported Q1'23 earnings Thursday night and hosted its latest earnings conference call on Friday morning. President & CEO J. Christopher Donahue comments in a press release, "Federated Hermes' record assets under management were driven by money market asset increases accompanied by further increases across nearly all other long-term asset classes from the previous quarter, demonstrating once again the value of our diversified business mix. As interest rates continued their rise and as investors considered regional banking issues, many withdrew deposits from small and medium-sized banks and continued to embrace the benefits of money market funds -- high credit quality, short duration, diversification, transparency, daily liquidity and market yields. Federated Hermes had positive net flows into a range of our money market products -- from government to prime." (See the Seeking Alpha earnings call transcription here.)
The release says, "Money market assets were a record $505.8 billion at March 31, 2023, up $85.2 billion or 20% from $420.6 billion at March 31, 2022 and up $29.0 billion or 6% from $476.8 billion at Dec. 31, 2022. Money market fund assets were $357.3 billion at March 31, 2023, up $77.8 billion or 28% from $279.5 billion at March 31, 2022 and up $21.4 billion or 6% from $335.9 billion at Dec. 31, 2022.... Revenue increased $57.4 million or 18% primarily due to a decrease in voluntary fee waivers related to certain money market funds in order for those funds to maintain positive or zero net yields (voluntary yield-related fee waivers) and an increase in revenue due to higher average money market assets [vs. a year ago]."
It explains, "During Q1 2023, Federated Hermes derived 52% of its revenue from long-term assets (33% from equity, 13% from fixed income and 6% from alternative/private markets and multi-asset), 47% from money market assets, and 1% from sources other than managed assets. Operating expenses increased $56.2 million or 23% due to increased distribution expenses resulting primarily from lower voluntary yield-related fee waivers.... There were no voluntary yield-related fee waivers during the quarter ended March 31, 2023. During the quarter ended March 31, 2022, voluntary yield-related fee waivers totaled $75.8 million. These fee waivers were partially offset by related reductions in distribution expenses of $57.5 million."
On the earnings call, Donahue comments, "The first quarter increase reflected movement into money market strategies from bank deposits in March as investors became increasingly concerned following the failure of certain banks. Money market strategies also continued to benefit from favorable market conditions for cash as an asset class, higher yields, elevated liquidity levels in the financial system and favorable yields compared to bank deposits. As short-term interest rates peak, we expect market conditions for money market strategies will remain favorable compared to both direct markets and bank deposit rates."
Asked about state and local government investment pools, he replies, "There are many other opportunities on the state pool front and let's divide that up in certain ways. In many of these states, even where we have the main pool, there are sub-pools in the state as well. Those pools are always viewed as a polite competition for the big state pool, and the extent to which those pools don't buy the right securities or don't have the right yields or don't have sufficient size to make things happen, that tends to enable the big pool to get bigger and therefore our claim on assets to manage to grow. That's one part of it."
The Federated CEO continues, "Overall, it does not appear that the things happening to the regional banks are impacting the state pools. That business is done based on long-term contracts with long lead times with bid processes, and RFPs that are very complicated. So it's really hard for those state pools to turn on a dime. Obviously, that's a tough thing for getting new business, but it's a pretty good thing for keeping old business.... Whenever there is an opportunity in whatever state [we look at it]. We are working on right now a small handful of states ... where we think we can become the manager of the pool.... We are at an all-time high of $148 billion in state pools."
Money Market CIO Debbie Cunningham comments, "Chris mentioned the long lead time for ... taking over the state pools themselves and local government investment pools. But the participants don't have such long lead time, and the participants do have choices. They don't have to be in the state pools. They could be in a bank [and] they are oftentimes looking at money market funds as an alternative. We have a substantial amount of cash in our money market funds from participants in state pools, some of which we manage, some of which are managed by others. So there are a lot of competitors to this business."
She explains, "Much like our outlook for money market funds, however, our outlook for the state pools from a participant gathering assets basis going forward is excellent. Generally speaking, in an increasing rate environment ... assets are not going out that quickly. It's when they reach a terminal rate and actually start going down the other direction and getting lower, that money generally comes flooding into these types of products. And much like our money market outlook, we see the same trajectory for our state pools."
Cunningham adds, "There are a lot of cash flow idiosyncrasies with regard to the state pools, though. Generally the state [or] the local municipalities receive cash at certain times, the same with the school districts within those state pools, and then they have a period of time when they are no longer receiving the cash receipts or the disbursements from the state themselves but are rather spending it. So there are definitely annual cyclical cycles that we deal within those pools as well."
In response to a question on the debt ceiling, Cunningham responds, "[Yellen] will continue to use extraordinary measures until they're almost exhausted and then there'll be some resolution. So our expectation is similar to past experiences with this, that it will be passed, it will get resolved.... But we are not expecting any type of even a technical default from a U.S. Treasury perspective. Now having said that, the market has prepared over the course of the last decade, let's call it, for such an event from both an operational perspective, from a systems standpoint, etc. The ICI, SIFMA, their DTCC are prepared if there were a technical default of a single Treasury security in the marketplace, and there are ways of rolling debt within the current limit that exists, that again in our minds keep this ... a very remote event."
On rates, she says, "Our expectation, even when the Fed reaches the terminal rate, is not for rates to go back to zero. That's not normal despite the fact that people that have been in the market for maybe the last 15 years think that's the landing ... but in fact, it is not. So when you get rates that are 3%, 4% or 5% and you are at a point when the Fed is at the top of its cycle, you see flows into products like the ultra-short funds, the micro-short funds, the cash-plus funds, that will maintain those higher rates for a longer period of time because of the Fed is not taking a trajectory that takes it back to zero."
In reply to a question on competition, Donahue answers, "Recently we haven't noticed any new competitive pressures on pricing.... Customers have the ability to move ... and a lot of them use three or so different purveyors for their cash because they like diversification. If anything, you may see more of that ... given what happened in the banking world.... You mentioned other short-term investments like ETFs or ultra-short funds ... they have variable net asset values, so the ETF is never really going to be competitive with the money market fund. They don't pay dividends every day. You don't know if you're going to get a buck back or not.... If someone wants to do a longer cash thing, then fine, we have the products for that. But those products are not going to compete specifically with money market funds."
Cunningham comments, "The only thing I'd add to that is: generally, ETFs are settling on a T+2 basis -- that is certainly not what's expected and for the most part, needed and utilized in the liquidity world for money market funds. They are expecting T+0 settlement for putting their cash with us and for redeeming their cash for its various uses. So that's also a big negative [for] the ETF sector."
When asked about tax outflows and cash "sorting," Donahue replies, "So on cash sorting, ... that generally means that the customer is figuring out that maybe zero or 10 or 25 basis points is not the market for a cash return, and ... some of the banks are having to pay up in order to keep, maintain or gain deposits. [T]he marketplace having its effect, the deposit beta rate is basically and administered or concocted rate with the design of giving beta to the bank for its net interest income and there's a little shift because of what happened in the banking industry for how people are actually looking at that."
Finally, Cunningham adds, "If you look at deposits in the marketplace, total deposits are down several trillion, and it did not start just in March. It was kick-started in March ... but it began in earnest back in March of 2022 when the Fed began raising interest rates.... When you look at the deposit beta historically for banks in a rising interest rate environment, it's about generally 40%. In today's environment, we're still less than 20% from a deposit beta perspective.... It's hard to say what others will do. But given that they're nowhere close to that number yet, and we are close to reaching what seems like a peak or a terminal rate in short-term rates, there's still a lot to go in this ballgame. I'm not sure what exactly inning it would be, but I'd say, we're still in the first half."
