Analyzing the ability of a firm to pay its debt obligations is a critical input when determining creditworthiness. If a company has an unfunded pension liability, it increases the default risk for unsecured bonds. However, the authors determine that this liability is not fully captured in bond ratings.
What’s Inside?
Although unfunded pension liabilities do not appear to affect senior secured bonds, an unfunded pension liability competes for the recovery of unsecured bonds in either a bankruptcy reorganization or liquidation process. As a result, any deterioration in pension funding levels is generally associated with a rating downgrade for these bonds. Although an unfunded pension liability both increases default risk and reduces the resulting recovery rate for unsecured bonds, the authors determine that bond ratings do not fully capture the risk of an underfunded pension.
How Is This Research Useful to Practitioners?
Companies that sponsor defined benefit pension plans guarantee to provide a certain level of benefits to plan participants at retirement based on predetermined guidelines. Plan sponsors are liable for the payment of these benefits as well as any pension shortfall. How these underfunded pensions are assessed can have a significant impact on a firm’s capital structure as well as its capital investment decisions. Moreover, when a plan sponsor experiences financial distress, pension liabilities and bondholders will have to compete for the same cash flows. The aggregate pension funding shortfall for Fortune 1000 companies recently totaled $343 billion. This shortfall poses a significant risk for creditors holding unsecured bonds. Furthermore, the authors find that the effects of unfunded pension liabilities on corporate bond default probability and resulting recovery rates remain even after they control for bond credit ratings. In other words, rating agencies are not fully incorporating pension underfunding risks into their assessment of a firm’s creditworthiness. Bond investors, therefore, should not rely solely on bond ratings when making investment decisions concerning corporate bonds issued by firms with underfunded pension plans.
How Did the Authors Conduct This Research?
The authors build on prior research that generally observed that higher pension liabilities reduce bond ratings. Their work is closely related to research done by Franzoni and Marin (Journal of Finance 2006), who reported a pension underfunding anomaly in the stock market. But the authors focus on the bond market and examine how unfunded pension obligations affect bond default probability and its resulting recovery rate.
They use data from Compustat, Fixed Investment Securities Database, Altman–NYU Salomon Center Corporate Bond Default Master Database, and CRSP. Firms must have at least two years of pension accounting data available. American Depositary Receipts, real estate investment trusts, and stocks with prices less than $5 are excluded. The authors then examine the relationship between unfunded pension liabilities and bond ratings using a decile portfolio sorting method. All bonds issued by underfunded firms are sorted into 10 deciles based on pension funding ratios. They then compute the time-series average of bond ratings for all decile portfolios, as well as rating differences between the most underfunded decile, the least underfunded decile, and the overfunded decile portfolios. The authors’ results hold using both a univariate portfolio sorting method and multivariate regression as well as after they control for any potential endogeneity issues.
Abstractor’s Viewpoint
This research provides a unique analysis of the relationship between unfunded pension liabilities and corporate bond ratings. It is critical for investment professionals to understand how an underfunded pension can affect default probability and the resulting recovery rate. Ultimately, I would like to see further research that determines an optimal capital structure when an unfunded pension liability is present.