Bank downgrades: Should LDI investors be worried?

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.

Recap of the downgrades and the market impact

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.

Recent ratings trends for the US credit index

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. 

What we are watching in the banking sector going forward

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.

Impact and implications for IG-credit-heavy LDI-oriented allocators

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:

• Using the full IG corporate opportunity set combined with US Treasuries as part of the liability-hedging allocation — We generally recommend that plans consider using the entire IG corporate opportunity set, as opposed to a quality-constrained index such as a long corporate A and up index — and we think this recommendation could be beneficial in the event of further banking sector downgrades. In addition to roughly doubling the investable universe (in market value and number of issuers), this approach may help reduce concentration risk (sector and issuer) compared with using A and up indices alone.
• LDI allocations that include a US Treasury allocation in addition to the entire IG corporate opportunity set — This may help balance the overall credit risk (using a Duration Times Spread or DTS metric) of an allocation relative to the higher-quality discount rate liability. An allocation to US Treasuries may also provide a dedicated liquidity source and the flexibility to efficiently adjust liability-hedging benchmarks and portfolio duration should liability characteristics change with actuarial assumption changes and other refinements.
• Diversifying liability-hedging allocations — Finally, for plans that are concerned with overall public IG credit exposure, there are a range of liability-hedging diversifiers to consider. We discuss these asset classes and strategies and the roles they can play in our new paper, Liability-hedging diversifiers: What’s on your pension’s playlist?. We also offer thoughts on liability-hedging portfolio construction in a previously published paper, The evolution of derisking: Assessing new and time-tested liability-hedging ideas, which is available upon request.