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Downgrades Possible for Large Global Banks

By SEI Investment Management Unit

Moody's Investors Service recently announced it may lower the credit ratings for 17 large global banks by the end of June. Included on the list are five of the six largest U.S. financial firms by assets: Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase and Morgan Stanley. Moody’s has cited diminished profitability as the main driver behind the downgrades. 

This development should come as no surprise to investors, as Moody’s has been conducting a review of more than a hundred global and European banks since February. In previous commentaries, we noted that this cast a shadow over financial markets. However, major U.S. bank stocks appear to be trading primarily on Europe-related headline risk at this point, suggesting that markets have fully discounted the potential impact of a downgrade.

Our View

In the overall banking space, we believe that the downgrades have already been priced-in. As such, we do not expect a significant reaction in the bond market, nor do we expect drastic setbacks to stock prices. In our opinion, the real impact of the potential downgrades will be seen in money market funds.

Money market funds are required to invest in AAA-rated paper. While a downgrade would not force funds to sell existing holdings, it would further restrict the universe of good issuers, making it more challenging to purchase securities in the future. In the municipal market, a downgrade would likely cause yields to increase, making it more expensive for municipalities to borrow.

The downgrade situation is more about Moody’s changing its rating methodology to reflect its view that banks and brokerage firms are undergoing long-term changes than it is about banks becoming lower-quality credits. If anything, we believe that banks have improved their positions in recent months. Stricter financial regulations should strengthen their balance sheets, and lower financial leverage should improve their credit profiles. It is also important to note that many banks are better capitalized, more transparent and have less-risky business models now than when they had AA and better credit ratings. 

Our Funds

Our current fixed-income positioning reflects our positive view toward banks, as our Funds are generally overweight versus their benchmarks.

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The Barclays Long U.S. Government Index includes U.S. Treasurys (public obligations of the U.S. Treasury that have remaining maturities of more than ten years) and U.S. agency debentures (publicly issued debt of U.S. government agencies, quasifederal corporations and corporate or foreign debt guaranteed by the U.S. government).

The Barclays Short U.S. Treasury 9-12 Month Index is a widely-recognized, market-weighted index of U.S. Treasury bonds with remaining maturities between nine and twelve months.

The Barclays U.S. Aggregate Bond Index is a benchmark index composed of U.S. securities in Treasury, Government-Related, Corporate, and Securitized sectors. It includes securities that are of investment-grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $250 million.

The BofA Merrill Lynch 3-Month LIBOR Constant Maturity Index is an unmanaged index of three-month constant maturity dollar-denominated deposits derived from interest rates on the most recent available dollar-denominated deposits.

The BofA Merrill Lynch U.S. High Yield Constrained Index is a modified market capitalization-weighted index of U.S. dollar-denominated below-investment-grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a below-investment-grade rating and an investment-grade-rated country of risk. In addition, qualifying securities must have at least one year remaining to final maturity, a fixed coupon schedule and at least $100 million in outstanding face value. Defaulted securities are excluded. The Index contains all securites of The BofA Merrill Lynch U.S. High Yield Index but caps issuer exposure at 2%.

The JP Morgan EMBI Global Diversified Index tracks the total returns for U.S. dollar-denominated debt instruments issued by sovereign and quasi-sovereign entities.

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