Companies facing the biggest pension deficit since at least 1994 are selling bonds at the fastest pace in more than seven years to plug the hole, betting that future returns will exceed their borrowing costs.
United Parcel Service Inc., the world’s largest package- delivery business, Dow Chemical Co., Northrop Grumman Corp. and PPG Industries Inc. sold at least $5.25 billion of investment- grade U.S. corporate bonds in November to fund their pensions, making it the busiest month since June 2003, according to data compiled by Bloomberg.
The Federal Reserve’s effort to hold down interest rates to stimulate the economy has caused corporate pension obligations, which are pegged to bond yields, to rise by $105.8 billion this year to $1.44 trillion as of October, according to Milliman Inc. Now, companies are taking advantage of borrowing costs at about the lowest on record as Goldman Sachs Group Inc. says interest rates will rise as the global economy recovers.
“They’re fighting fire with fire,” John Lonski, chief economist at Moody’s Capital Markets Group in New York, said in a telephone interview. “They’re being victimized by low bond yields, so why not go ahead and use them as an offset?”
Investment-grade corporate bond yields, used as a benchmark to determine future corporate liabilities to retirees, fell to 3.53 percent on Nov. 4, the lowest ever, Bank of America Merrill Lynch index data show.
Corporate pensions in the Standard & Poor’s 500 Index with about $1 trillion in assets are 77 percent funded this year, down from 82 percent at the end of 2009, Bank of America Merrill Lynch said in an Oct. 29 report. Few, if any, borrowers have had their credit ratings cut for issuing debt to fund pension obligations, Lonski said.
Yields may not move substantially higher over the next several years, he said. “They’re willing to make a gamble that future returns will exceed the current cost of debt,” he said.
Elsewhere in credit markets, the extra yield investors demand to own company bonds instead of similar-maturity government debt rose 1 basis point to 170 basis points, or 1.7 percentage points, the highest since Oct. 7, according to Bank of America Merrill Lynch’s Global Broad Market Corporate Index. Yields averaged 3.714 percent.
The cost of insuring bonds sold by Portugal jumped 31.5 basis points to 507.5, while those on Spain soared 21 basis points to an all-time high of 320.5 according to data provider CMA.
Speculation is mounting that Portugal will be forced to accept aid to stop contagion spreading to Spain. Ireland was made to ask for a rescue on Nov. 21, eight days after officials were pressed on an ECB conference call to accept emergency funds.
The Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, added 2.5 basis points to a mid- price of 96 basis points as of 11:55 a.m. in New York, according to index administrator Markit Group Ltd.
Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company or country fail to adhere to its debt agreements. A basis point on a contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.
The $380 billion pension shortfall is the biggest since at least 1994, David Bianco, chief U.S. equity strategist at Bank of America Merrill Lynch in New York, said in last month’s report.
Goldman Rate Prediction
The Fed has kept its benchmark rate in a range of zero to 0.25 percent since December 2008 to stimulate the economy and reopen debt markets after the worst credit seizure since the Great Depression. This month the central bank said it would buy more Treasuries to keep interest rates lower and prevent deflation.
Goldman Sachs’s rates team expects longer-maturity Treasuries to rise “on economic recovery, both in the U.S. and globally, and the normalization of U.S. inflation expectations,” strategists Charles Himmelberg, Alberto Gallo, Lotfi Karoui and Annie Chu wrote in a Nov. 19 report. Yields on 10-year Treasuries will rise to 3.3 percent by the end of next year, the New York-based firm said.
“If you truly believe that rates are going up, you should be issuing debt,” said Gordon Latter, a managing director at RBC Global Asset Management in Minneapolis. Latter said his firm is proposing that clients issue bonds to help fill pension deficits.
Pension Funding Gap
The gap between the assets of the 100 largest company pensions and their projected liabilities has improved for two months after widening by $108 billion in August to a $459.8 billion deficit, the biggest shortfall in at least a decade, Seattle-based actuarial and consulting firm Milliman said in a statement.
The pension plans have a median 8.1 percent expected rate of return, Milliman said. During the past 12 months, assets in the plans returned 11.4 percent while the funding status dropped $21 billion, “due primarily” to lower discount rates.
Getting an 8.1 percent return is “very difficult” given recent Treasury yields, said Ashish Shah, co-head of global credit investment at AllianceBernstein LP in New York.
“You’d probably have to take a greater amount of risk than most plans feel comfortable with to get that kind of return today,” Shah said in a telephone interview.
The S&P 500 Index has gained 9.4 percent this year, including reinvested dividends. U.S. corporate bonds have returned 9.9 percent, and Treasuries have handed investors 7.2 percent, according to Bank of America Merrill Lynch index data.
While replacing a pension liability with corporate debt may reduce volatility, issuing bonds may restrict a company’s financial flexibility, said Jon Waite, a director and chief actuary at investment manager SEI, which oversees more than $164 billion in assets in Oaks, Pennsylvania.
“It’s a real juggling act for the” chief financial officer, Waite said in a telephone interview.
Companies also are using their cash stockpiles to fund pension obligations because they’re skittish about economic growth and aren’t inclined to hire more workers or invest in their businesses, said Tom Meyers, head of client portfolio management at Chicago-based Legal & General Investment America, which oversees about $18 billion.
“It’s not surprising that contributions to plans have been taking place at a very serious and meaningful rate,” Meyers said in a telephone interview. “Issuing bonds to fund pension plans, it strikes us as opportunistic.”
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