Corporate Bond Yields, Interest Rates, and Pension Liability Discounting
Summary
The discussion explains why an AA corporate bond yield can be used to discount corporate pension liabilities and how it relates to interest rates. A discount rate is an interest rate, but the appropriate rate depends on the liability and the purpose of valuation. Using expected stock returns is criticized as a poor fit for pension promises because equities carry substantial risk. An AA corporate yield may be a reasonable corporate benchmark because pensions are obligations owed by the company; government pension liabilities may instead be discounted at a long-term risk-free rate.
Corporate bond yields combine the risk-free rate with a credit spread, so they are related to, but not identical to, risk-free interest rates. The discussion emphasizes that small rate differences can materially change the present value of long-term liabilities, and that the choice also affects incentives for companies and employees. It offers conceptual guidance rather than a quantitative comparison or universal rule; the appropriate discount rate remains a debated judgment.
Key ideas
- A discount rate is an interest rate, but different liabilities can justify different rates.
- AA corporate yields may suit corporate pension liabilities because they reflect the employer's borrowing costs.
- Corporate bond yields include both a risk-free component and a credit spread.
- Small changes in discount rates can materially affect the present value of long-term pension obligations.
- Government pension discounting may use a risk-free rate, and the choice remains contested.
Tags
Full text
# Relationship between interest rate and corporate bond yield? # Relationship between interest rate and corporate bond yield? I have been reading articles on liability driven investing, a technique used to increase the correlation b/w assets and liabilities of a pension plan. It appears that they use AA rated corporate bond yields to discount the liabilities. At the same time, the articles say that interest rate is the dominant influential factor for liabilities. So are interest rate and corporate bond yields(AA in this case) are the same thing? Or are they highly positively correlated? ## Answer by Alex C (score 2, accepted) https://quant.stackexchange.com/a/26159 Anything that is used for discounting is by definition an "interest rate". But then the question arises what is the appropriate choice of interest rate to use for discounting pension liabilities. There are many possibilities (many interest rates). Some want to use the expected return on the stock market as the interest rate. That is a very bad choice (although popular), because stock returns are quite risky while a pension is not supposed to be. A reasonable choice is the AA corporate bond rate. After all a pension is a kind of "debt" (a promise to pay) that a corporation owes to its employees, so it make some sense that the discount rate should be similar to the rate that the corporation pays on its corporate bonds. For state and federal government pensions the issue is more debatable. Since the federal government borrows at the long term risk free rate it may make some sense to use this rate in discounting Social Security and other government sponsored pensions. This rate is lower than the AA rate. The whole question of which interest rate should be used is very delicate. Because pensions liabilities are long term, even a small difference in interest rate makes a big difference in the p.v. of the pension liabilities (as you said). Also, it is in the corporations interest to use as big a discount rate as they can to minimize the (reported) presen value, whileit is in the meployees interest to use a smaller interest rate so the company will set aside more money now and make their pension more secure. ## Answer by g g (score 1) https://quant.stackexchange.com/a/26149 You earn coupons on a corporate bond portfolio and in this sense corporate bond yield is an interest rate. But it is important (especially in liability driven investment) to recognise that corporate bond yield has two quite different components: credit spread and riskfree interest rate. To quote from Wikipedia Corporate bond: "High Grade corporate bonds usually trade on credit spread. Credit spread is the difference in yield between the bond and an underlying US Treasury bond (for US Dollar corporates) of similar maturity. Credit spread is the extra yield an investor earns over a risk free instrument (US Treasury) as a compensation for the extra risk." The lack of interest in your question on this site might be explained by the fact that it can be answered by a straightforward look at Wikipedia.
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