Keeping in with the rating agencies
For companies that depend on the bond markets for financing, the importance of their credit rating cannot be overstated. A satisfactory credit rating in this context means at least single A (the lowest ‘investment grade’ rating) but many issuers aim to achieve AA and a few are AAA. The choice of the yield on AA corporate bonds as the discount rate for accounting purposes is because there is a deep market in AA bonds and so a suitable rate is available for any duration.
There are three major global rating agencies, Standard & Poor’s (S&P), Moody’s Investor Service (Moody’s) and Fitch. Fitch is somewhat less established in the international markets although of long standing in the US, and most issuers requiring (as is normal) two ratings will go for S&P and Moody’s.
Bond investors tend not to have available to them the range or volume of analyst opinion that is available to equity analysts. They rely primarily on the rating agencies to tell them how secure lending to a particular borrower is likely to be. Usually a bond will be outstanding for five years or more and rating analysts take a longer term view of the company compared with equity analysts. The agencies like to say that they “rate through the cycle” so that the rating should be stable over a period of years despite economic ups and downs. Ratings normally change gradually but bigger changes can occur if the unexpected happens; most frequently a merger or acquisition or a buy-out that results in significantly increased gearing.
Issuers put a lot of effort into their relationships with the rating agencies and provide them with information that is not publicly available. Some commentators have been surprised that the appearance of large pension fund deficits on the balance sheets of European companies has not led to a rating downgrade. There are two main reasons for this. One is that the agencies are “insiders” and have access to unpublished information that will generally have included some estimate of pension commitments. The other is that the credit analyst’s focus is on the cashflows generated by the company and its ability to service liabilities, rather than the relative value of assets and liabilities that is the focus of accounting figures. Of course the two are connected, but an increase in balance sheet liability generated solely by a change in the discount rate will generally not have much of an impact on cashflows. The discount rate goes up and down with the market whereas the cashflows are long term and respond to longer term changes.
Usually rating agencies will use the financial information provided to model the future cashflows of the company. However for pensions and other post-retirement benefits the cashflows are so uncertain that the agencies use instead a sensitivity analysis to see what the effect on the company would be under a range of scenarios. These scenarios will take into account the regulatory environment and likely developments as well as the funding situation of the schemes and changes in assumptions underlying the valuation of liabilities.
For companies in countries where the government bears part or all of the pensions risk, the cost to the company of the resulting tax burden is also taken into account. The objective is to assess companies on a near to a level playing field as is possible given the wide variation in national arrangements.
Accounting figures, as noted above, will have little direct effect. What the rating analyst is looking for is evidence that the company’s cashflows, generated primarily by profits, will continue to cover pension contributions. The agencies pay particular attention to the assumptions used to produce the figures and if, for example, Moody’s believes that the discount rate or the assumed returns on pension assets are “unsustainable or significantly different than those of a company’s peers”1 they will challenge management’s thinking and if necessary adjust their forecasts.
Companies using actuarial assumptions that are out of date will not escape lightly and will need to convince the analyst that they are managing this risk adequately. A change in mortality assumption for a company whose pension commitments are large relative to their market capitalisation could well trigger a rating downgrade.
Regulators are a particular concern here. If a company is required by regulation to maintain a certain funding level relative to a liability calculated at a particular discount rate, changes in that rate will have a very direct affect on cashflow and possibly the rating.
This really depends on the credit strength of the company. In 2004, Marks and Spencer raised £400m (e590m) debt to fund its DB pension scheme. If unfunded liabilities are treated like debt, it should in theory make little difference whether the liability is funded or not. In this case, the extra debt burden did not result in a rating downgrade but for a less credit-worthy borrower it may well have done. This is because in most countries lenders take precedence over pensioners in an insolvency situation.
Raising debt to fund the liability puts the proceeds beyond the reach of the company’s creditors so they are disadvantaged relative to pensioners. Unless the company’s cashflow is very strong, the creditors’ position has weakened and the rating should fall. (On the other hand, the tax benefit of raising debt can provide a welcome boost to profit, although this would not be enough to affect the rating.)
It is important to note that pension liabilities are taken into account in the rating process whether they are funded or not. Indeed Standard & Poor’s (S&P) states that it “views unfunded liabilities relating to defined benefit pension plans and retiree medical plans as debt-like in nature”2. Postretirement medical plans are mostly a feature of US companies but of course many Europe-based multinationals have taken on these liabilities with the acquisition of US subsidiaries.
One company has said that this was a significant part of their overall risk but particularly difficult to measure. This seems to be an area where the two big agencies take a different view as Moody’s does not in general treat retiree healthcare benefits as debt3 but may do after discussion with management. One of the issues for discussion would be management’s plans to shift part of the cost onto employees, which in general they are able to do, unlike pensions.
Moody’s approach1 to estimating the impact on debt of pension commitments is to look at the funding shortfall (under a range of assumptions) and use that figure as the debt-like liability. In the case of unfunded schemes they look at the company’s mix of debt and equity excluding pension schemes and use as an estimate of the pension debt the percentage of the unfunded liability that would be debt financed if the company maintained the same gearing. In other words, if the debt/equity ratio was usually around 60/40, they would take 60% of the pension liability as debt.
Rating analysts pay close attention to a company’s gearing ratio, with particular attention to the terms and conditions of loan and bond documentation. Some loan documentation contains financial covenants and these commonly include a restriction on gearing. The idea is to restrict a company’s ability to raise additional debt, which would weaken the position of existing lenders, a key issue for the rating agencies.
Up to now, pension fund liabilities have not been on the balance sheet and so not included in the ratio. With new accounting practice, companies may be faced with a large and volatile item in the balance sheet which may cause the breach of such a covenant. The analysts needs to be sure that the company is fully aware of its exposure and is taking steps to re-negotiate with its lenders if necessary.
So far the rating analyst’s primary focus has been on the cash outflows required to fulfil pension commitments, but they also look at how the company is generating cash inflows. S&P points out: “ A company’s post-retirement obligations affect its financial position, and also may be germane to its competitive position. Most problematic is when peers face different retiree costs.
Companies that have been relatively generous, have an older workforce or have a comparatively large number of retirees, cannot raise their own selling prices any more than those of their competitors.”2 And, of course, businesses vary in the size and nature of these commitments depending in which countries they are operating, potentially another source of competitive advantage or disadvantage.
Pension commitments can also affect a company’s ability to finance business expansion. Growth companies often maintain a lower level of debt to equity than they could comfortably manage in cashflow terms, in order to leave space on the balance sheet (“financial flexibility” is one of Moody’s key rating criteria) to fund expansion. Most companies rated AA will be in this position. Moody’s notes that the need to fund pension liabilities could “impair the company’s ability to make other critical business investments” and in some instances may result in a lowered rating4.
Above all else, the agencies will expect management to have a well developed strategy for dealing with the risks inherent in pension plans and to have thought through both the financial and human resource implications. Even though management’s ability to reduce risk in this area is limited, highly rated companies will be expected to closely monitor their global position in the light of changing actuarial assumptions and regulatory action, and to make cost savings and reduce risk wherever possible without undermining employee relations.
A lower credit rating would not necessarily make it so difficult for the company to borrow that its future was in doubt, but any debt raised would certainly be more expensive, affecting profits, and the amount available might be more limited, affecting growth. Sometimes this is the price a company has to pay in order to achieve other corporate objectives.
1 Moody’s Approach To Global Standard Adjustments In The Analysis Of Financial Statements For Non-Financial Corporations – Part 2, Section 1 Defined Benefit Pensions: September 2005
2 Standard & Poor’s Corporate Ratings Criteria 2005, Post-retirement Obligations.
3 Moody’s Rating Methodology, Other Post-retirement Benefits – Moody’s Analytical Approach: December 2004
4 Moody’s Rating Methodology – Analytical Observations Related to US Pension Obligations: January 2003