Corporate Pension Funding and Credit Spreads

This study empirically tested whether pension information derived from accounting disclosures is priced in corporate bond spreads. The model was tested on corporate bond data of U.S. companies for the 2001–04 period. Unfunded pension liabilities are incorporated in credit spreads, and the sensitivity of market spreads to deficits is greater than the sensitivity to ordinary long-term debt. This relationship is not, however, a linear monotonic function, and the sensitivity of bond spreads to deficits is substantially higher for high-yield than for investment-grade bonds. Moreover, the bond market prices residual risk even in funded obligations and gives lower weighting to off-balance-sheet liabilities.The study described in this article tested empirically whether pension information derived from accounting disclosures is priced in corporate bond spreads. The model used was built on the literature of structural models of bond spreads initiated in the 1970s. I tested it on corporate data and bond data for U.S. companies for the 2001–04 period.A number of studies have considered the relationship between pension funding and corporate financial policy. Although some studies have questioned the value transparency of the stock market when it comes to processing information derived from pension accounting data (that is, whether stock prices correctly incorporate pension liabilities in the valuation of companies), no previous work has investigated the extent to which traded corporate bonds incorporate pension liabilities in the implicit assessment of company creditworthiness embedded in market spreads. In fact, previous studies of the bond market’s response to corporate pension liabilities took an indirect approach by calibrating models of credit ratings.The intuition behind the empirical specification in this study was that credit spreads are explained by proxies of leverage and volatility of the value of the firm (typically proxied by the volatility of the stock price), which is consistent with a structural model approach. My analysis was made possible by a unique set of data matching a four-year dataset of Fortune 1000 pension and accounting disclosures maintained by Watson Wyatt Worldwide with data on corporate spreads supplied by Merrill Lynch & Co. For the purpose of the analysis, the sensitivity of market spreads to pension liabilities was captured by separating out pension leverage arising from the presence of a defined-benefit plan from ordinary leverage arising from corporate debt. Pension leverage was then further broken down into a funded component backed by pension assets and an unfunded component representing the plan deficit.Consistent with previous studies on credit ratings, I found that the U.S. corporate bond market takes into account the presence of unfunded pension liabilities. The effect was strongest for below-investment-grade (high-yield) securities. I also found the sensitivity of spreads to pension deficits to be much larger than their sensitivity to ordinary long-term debt. In the baseline econometric specification, the pension deficit coefficient was twice as large as the coefficient associated with ordinary long-term debt for the investment-grade sample and more than three times larger for the high-yield sample.The article also provides evidence suggesting that the relationship between pension deficits and spreads is rather more complex than a linear monotonic function; therefore, a linear regression model can provide only a first-order approximation. Moreover, although the market does seem to take reported pension deficits into account, it also appears to consider additional factors when incorporating corporate pension fund information in a credit-risk framework. In particular, the market apparently takes into account residual risk even in funded obligations and gives a lower weighting to off-balance-sheet liabilities. The evidence as to whether liability duration and plan asset allocation are also priced as separate risk factors is not conclusiveThe results of this study suggest that fixed-income portfolio managers should explicitly incorporate plan deficits and other pension fundamentals in their models of corporate credit spreads. And managers should assess the impact of pension variables as risk factors separate from ordinary leverage. Such an exercise appears to be most important for high-yield securities.Editor’s Note: This article is the result of work carried out while the author was senior economist at Watson Wyatt Worldwide, Reigate, United Kingdom.