Profit From Rising Interest Rates by Investing in Discount Brokerages

John is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

With the Fed announcing in June that it may soon stop purchasing treasuries and mortgages as long as the U.S. economy continues improving, investors are bracing for the inevitable rise in interest rates that had remained depressed since 2008. While rising interest rates may hurt certain investment strategies such as going long treasuries, it can also provide opportunities for the savvy investor. I believe one particularly effective method of capitalizing on the impending rise in interest rates is investing in discount brokerages such as Charles Schwab (NYSE: SCHW), TD Ameritrade (NYSE: AMTD), and E*Trade Financial (NASDAQ: ETFC). I believe that among these three discount brokers, Schwab and TD Ameritrade represents the safest choices. E*Trade offers more leverage to rising interest rates, but its poor financial health may mean that its risks outweigh its rewards.

Leverage to rising interest rates

There are two main reasons for why discount brokerages offer ample upside from higher interest rates. For one, in a higher interest rate environment, discount brokers will be able to generate significant interest income through investing the "float," or the cash that clients park in their investment accounts in short-term fixed income investments, as well as through charging interest on margin loans that customers take out for their accounts. This interest income comprises a significant portion of the three discount brokerages’ revenue, and is a major profit driver. The table below depicts the trend in interest revenue for Schwab, TD Ameritrade, and E*Trade during the past several years.

Interest Revenue for Discount Brokers (in $ millions)

  2007    2008    2009    2010    2011    2012   
Schwab $2,270 $1,908 $1,428 $1,723 $1,900 $1,914
TD Ameritrade    $1,014 $799 $362 $428 $497 $456
E*Trade $3,575 $2,477 $1,833 $1,547 $1,532 $1,371

As interest rates inevitably rise, discount brokers will be able to earn a higher return on their float as well as on margin loans, which will lead to a significant spike in total sales given that interest revenue is already such a big portion of total revenue for these companies. Even better, much of this increase in interest revenue will fall directly to the bottom line, since there are no extra expenses the brokers need to incur to earn this higher interest revenue.

Granted, the discount brokers will have to share some of the bounties of higher interest rates with customers by passing through some of the higher returns to the client accounts. But sharing some of the profits from higher interest rates would sure beat not having much interest income to share in the first place. In its 2012 year-end report, Schwab estimates that a 100 basis point increase in interest rates would increase its net interest revenue by 19.2%. Given that Schwab’s net interest revenue in 2012 was $1.76 billion, this implies that a 100 basis point increase in interest rates would have boosted Schwab’s pre-tax profits by roughly $0.27 per share. For sake of reference, Schwab’s pre-tax income in 2012 was $1.15 per share, so the projected gains from higher interest revenue are quite material.

No more fee waivers

The second way discount brokers can win from higher interest rates is by reinstating money market fees that have been waived during the past few years. Brokers like Schwab were forced to waive the asset management fees they charge for holding customers assets in money market accounts in recent years because customers would have earned a negative nominal return on their cash if they were charged the normal fees given the dismal rate of return on money market investments. With higher interest rates, and a corresponding increase in money market rates, I think discount brokers will slowly be able to reinstate asset management fees on customer’s money market accounts. Currently, the lost income from waived money market fees are significant, with Schwab estimating that it waived $587 million in fees in 2012, representing $0.46 per share in pre-tax profits. If discount brokers are able to bring these fees back thanks to higher interest rates, their bottom lines would almost certainly receive a sizable boost.

Conclusion

With interest rates almost certain to rise over the next several years thanks to the Fed instituting tighter monetary policy, discount brokers stand to greatly increase their bottom lines by generating higher interest revenue as well as by reinstating money market fees which were previously waived. Among the three discount brokers discussed, I believe that Schwab and TD Ameritrade are the best-of-breeds with strong financial health and a robust and growing asset base.

While E*Trade Financial may offer more leverage to higher rates because it generates a higher percentage of its total revenue from interest revenue, the company also has a weak balance sheet with a debt to equity ratio of 0.62 at the end of 2012 compared to Schwab and TD Ameritrade’s ratio of 0.19 and 0.31, respectively. Looking at valuation multiples Schwab traded at roughly 31 times trailing twelve month (TTM) earnings, while TD Ameritrade traded at roughly 23 times TTM earnings. While these earnings multiples might seem a bit high, investors should remember that earnings per share for the discount brokers have room to spike much higher with even a modest increase in interest rates, as discussed in previous sections. As such, Schwab and TD Ameritrade are worth a look for investors seeking for a way to directly profit from a higher interest rate environment.


John Park has no position in any stocks mentioned. The Motley Fool recommends TD Ameritrade. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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