The competitive and economic environment for Charles Schwab SCHW and other retail brokerages has dramatically changed over the past year. Charles Schwab merged with longtime peer TD Ameritrade, while E-Trade merged with Morgan Stanley MS after commissions on many common types of trades were set to $0 in October 2019. In 2020, the global economy went into free-fall as a result of COVID-19, and monetary authorities have cut interest rates to near 0%. The world is likely to be in another extended period of lower interest rates, similar to after the 2008 financial crisis.
Given the precipitous decline in net interest revenue and a triple-digit spike in trading volume, we decided to provide an assessment of whether we've hit bottom for interest-rate-related income and whether current trading volume is sustainable. For net interest income, we believe there's still room to fall from prepayments and the reinvestment risk inherent in Charles Schwab's mortgage-backed securities portfolio. TD Ameritrade's interest-rate-related bank deposit account agreement revenue with Toronto-Dominion Bank TD will also face significant headwinds, but its merger with Charles Schwab has mitigated the earnings impact. Money market fund fee waivers are also likely to double in the following quarters.
Trading volume is up 100%-350% at the retail brokerages as a result of several permanent and transitory factors. We believe the move to $0 commissions has permanently elevated trading volume for the retail brokerages. But we also believe volume related to COVID-induced market volatility, changes in behavior due to self-quarantining, a massive run in technology stocks, and the anecdotal rise in recreational traders will prove transient. Ultimately, we forecast that retail brokerage trading volume may fall 20%-50% from recent levels but remain significantly higher than it was before $0 commissions.
- We believe four factors contribute to the triple-digit growth in retail brokerage trading volume: (1) the move to $0 commission trades, (2) market volatility caused by COVID-19, (3) behavioral changes from self-quarantining, and (4) the strong recovery in the stock market.
- After adjusting for what we consider to be transient factors driving volume, we assess that normalized retail brokerage trading volume may be 20%-50% lower than its levels in the third quarter of 2020.
- In the short term, U.S. interest rates have been near 0%, and the 10-year U.S. Treasury yield has been below 1% for over two quarters. However, we don't think that the yield on Charles Schwab's legacy securities portfolio has bottomed yet. U.S. agency mortgage-backed securities account for the bulk of Charles Schwab's securities portfolio, and much of that is subject to significant prepayment and reinvestment risk.
- We forecast that the yield on Charles Schwab's legacy securities portfolio will decline to approximately 1.30% in 2022 from 2.67% in 2019 and 1.59% in the third quarter of 2020. This leads to a reduction in gross interest income of $1.5 billion from 2019 and $800 million from the third-quarter 2020 run rate.
- Revenue related to TD Ameritrade's bank deposit agreement with Toronto-Dominion Bank, which Charles Schwab inherited with its merger, is facing significant headwinds. As a stand-alone company, TD Ameritrade may have experienced annual revenue declines of $200 million-$300 million from the maturing and reinvestment at low rates of its bank deposit agreement balances.
- After the merger with Charles Schwab, the headwind from TD Ameritrade's bank deposit account agreement has lessened by approximately $80 million annually, as Charles Schwab moves deposits from Toronto-Dominion Bank into its own bank subsidiary.
- Fee waivers on money market funds are likely to double from recent levels, despite U.S. short-term interest rates having been near 0% since March.
- We currently assess Charles Schwab's shares as fairly valued. If the stock were to fall as near-term headwinds in interest rates, trading, and TD Ameritrade revenue dissynergies materialize, we would gladly buy it. Charles Schwab is not only an investment-services leader but a financial sector leader. Additionally, earnings should receive a material lift in the medium term from TD Ameritrade expense synergies and a boost in the long run from higher interest rates and transfer of TD Ameritrade client cash into Charles Schwab's bank.
This information was published Nov. 23 as part of a larger report, which is available to Morningstar's institutional clients.