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In August, Moody’s and S&P downgraded several US regional banks as the industry stress that roiled markets earlier in 2023 continued to take a toll. Our LDI and investment-grade (IG) credit teams have been thinking through the implications for plan sponsors. In summary, we do not expect the downgrades to have a negative effect on IG-credit-heavy LDI strategies or on funded ratios (“downgrade drag”). The affected issuers make up a relatively small portion of the US IG credit index and conditions in the broader IG market remain positive in our view.
That said, the banking industry may continue to face headwinds. Recent regulatory changes will require more debt issuance as regional banks look to address their capital shortfall over the next three years, which may add to downgrade risk and increase financials’ weights in already concentrated indices.
Moody’s downgraded 27 US regional banks by one notch in August, while also issuing negative outlooks on seven banks and putting five on negative watch. This resulted in US$196 billion in downgrades, a big number but not especially concerning in the context of the US$1.44 trillion banking sector. What’s more, only one bank was removed from the A rating indices, as all other ratings changes were within the A rating. In August, we also saw S&P downgrade five banks by one notch and Fitch warn that it may need to downgrade selected banks.
While the downgrades grabbed headlines, they were not unexpected and only three of the impacted names have meaningful debt outstanding. None of the downgraded names are included in the Bloomberg Long US Corporate Index, and the three included in the Bloomberg Intermediate US Corporate Index, which has a larger footprint in banking (30%), make up less than 50 bps of the index in aggregate. So, the overall impact on the indices — and therefore on funded ratios — has been fairly muted. Generally, we have been cautious on regional banks in the index, though we think there is some differentiation among issuers. More thoughts on the US regional banking sector from our finance team on the equity side can be found here: US regional banking sector update.
Overall, we have seen positive net upgrades for IG credit since 2021, with a large number of rising stars (bonds moving from high yield to investment grade stand at close to US$200 billion per JP Morgan). This has been helped by robust fundamentals and a supportive economic backdrop. Upgrades in watches/outlooks for US credit indices are near historically high levels and the portion in “negative watch” remains near record lows.
This stands in contrast to the negative net-downgrade trend and migration from A to BBB/BBB+ between 2010 and 2020, when rating agencies grew uncomfortable with companies taking advantage of extremely low after-tax borrowing costs to optimize their capital structures.
Regulatory changes on the horizon could have an impact on banking sector spreads over time. In particular, in late July, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation issued a joint notice of proposed rulemaking that would apply to banks with total assets of US$100 billion or more and would bring risk-based capital requirements more in line with Global Systemically Important Banks and incorporate unrealized gains/losses from available-for-sale securities into capital calculations.
Regional banks could be impacted most by the new regulation, since they have larger capital shortfalls to fill. Depending on the size of the new issuance needed and the timeline, there could be pressure on banking spreads in the intermediate part of the curve in particular. That said, it should be a positive fundamental factor for the banks looking forward, as they will end up with stronger capital buffers. Banks typically issue shorter-maturity debt rather than longer-maturity debt because they don’t have a lot of long-term assets (>10 years) — hence, the lower concentration in the long corporate/credit bond indices. We don’t expect much issuance or impact on credit spreads at the long end of the market.
To summarize, we do not expect these regional bank downgrades to have a negative effect on LDI strategies. As noted, most of the impacted ratings are high to mid-single A bank bonds, and the effect is further limited largely to the intermediate corporate index, which tends to be a smaller component of most LDI strategies than the long corporate index. In addition, the regional bank ratings changes occurred against a backdrop of positive net upgrades for IG credit since 2021. Funded-ratio deterioration from downgrades tends to be worst when downgrade activity is elevated.
However, we do have a few recommendations for plan sponsors to consider:
Setting ROAs for 2024: A guide for US corporate and public plansContinue reading
Liability-hedging diversifiers: What’s on your pension’s playlist?Continue reading
Keep your spread and earn on it too? The case for intermediate creditContinue reading
Mind the liquidity (and cost) gap: Revisiting a plan’s hedge-ratio approachContinue reading
LDI in 2023: Ten questions corporate plan sponsors are askingContinue reading
Setting ROAs for 2023: A guide for US corporate and public plansContinue reading
Setting ROAs for 2024: A guide for US corporate and public plans
How are pension plans adjusting their ROA assumptions? And how do those assumptions line up with our long-term capital market assumptions? Find out in this annual update.
Liability-hedging diversifiers: What’s on your pension’s playlist?
Corporate pensions moving closer to their end state may benefit from more diversified liability-hedging allocations. To help, LDI Team Chair Amy Trainor offers a liability-hedging diversifiers “playlist” — a set of asset classes and strategies that may harmonize well with a variety of objectives, from downside mitigation to long-term outperformance versus long corporate bonds.
Keep your spread and earn on it too? The case for intermediate credit
Amid heightened volatility and an uncertain macro environment, members of our LDI Team see opportunity for corporate plans in the intermediate credit market.
Mind the liquidity (and cost) gap: Revisiting a plan’s hedge-ratio approach
Members of our LDI Team take a fresh look at the process of setting and managing liability hedge ratio targets, including liquidity considerations that are top of mind today and the implementation toolkit.
LDI in 2023: Ten questions corporate plan sponsors are asking
Members of our LDI Team address a range of topics that US corporate plans will be thinking about in the coming year, from the investment implications of pension accounting changes to the role of alternatives in a return-seeking portfolio.
Setting ROAs for 2023: A guide for US corporate and public plans
How are pension plans adjusting their ROA assumptions? How do those assumptions line up with our long-term capital market assumptions? Find out in this annual update.