Tag Archives: inflation

More thoughts on Inflation (Linkers, Pension liabilities, highly indebted Countries)

As inflation is something that we haven’t seen for a few decades, I am still trying to get my head around this trying to understand how this could influence investments going forward.  In this posts I just wanted to touch three areas: Inflation linked bonds, pension liabilities and highly indebted countries. 

  1. Inflation linkers

When looking for assets that gain or at least compensate for inflation, one should not forget Inflation linked bonds. Per construction, they compensate at least fully for the officially measured inflation.

In addition, Inflation linked bonds function also as an instrument to observe “implied” inflation rates, I.e. the market price of an inflation linked bond contains the investor’s expectation for future inflation rate.

The German agency for debt has a good page (in German) that explains how these securities work. One thing to mention is that most bonds are linked to Eurozone inflation, not German inflation.

Looking at the detail page of the 2033 linker we can see that this bond carries a 0,10% coupon and trades at a yield of -1,73%.  Comparing this with the 2032 fixed rate bond (there is no 2033 fixed rate Bund) that yields around 1%, we can estimate that the difference between the two yields (1-1,73%)= 2,73% is the market’s current estimate for the inflation in the Eurozone for the next 10 years or so. (Remark: in reality, this is more complex, see for instance here, but for this exercise it is good enough).

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How to value IFRS 19 Pension liabilities – Part 2: Inflation

AFter the introduction and some technical aspects in the first part, let’s look at how inflation is impacting pension liabilities. Inflation in my experience is something which is widely misunderstood when it comes to pension plans.

In many countries, especially Germany and UK, defined benefit pension plans work in general the following way:

Accumulation/active phase:
For active employees, each year the work for the company, they get promised a pension in relation to their current salary. So the longer they work and the more they earn, the higher the future pension promise. Companies have to disclose the assumption for the increase in salaries. Salary increases are a function of inflation and promotion. People who work a long time in companies and get promoted, usually increase their salary much more than inflation. Nevertheless it is fair to assume that in many cases, inflation will be reflected in salary increases.

Payout phase
Once an employee has retired, his pension payments are often linked to an inflation rate. In Germany for instance, those payments are linked to the German CPI (consumer price inflation) but with a minimum increase of 1% in any case.

Inflation Compounding
What many people don’t realize is that a permanent increase in the inflation level has a compounding effect, the adverse effect of course with decreasing inflation level. Roughly, an increase in inflation by a certain percentage has the same “sensitivity” as the discount rate.

Example Thyssen:

Thyssen Krupp for instance uses in their annual report 2012/2013 the following assumptions (Germany):

– Inflation rate for pension payments 1.5%
– Wage increases 2.5%

They show that a 1% change in the discount rate will change the pension liability by around 920 mn EUR. With a current net pension liability of 6.2 bn we can “reverse engineer” the duration of the liability simply by dividing 20/6.2 bn ~ 15 years.

This duration can be used both, as a simplified multiplier for changes tinterest rates and changes in assumed inflation rates. For instance if one assumes 2% instead of 1.5% as future inflation, the pension liability would be 15×0.5%=7.5% higher than it is shown on the balance sheet.

Inflation expectation vs. break even inflation rates

Many people especially here in Germany do think that we will see higher inflation going forward. I would not base my inflation expectations on subjective opinions but on observable market prices. Luckily we do have observable market prices for inflation: So called “inflation break even rates“, i.e the yield differences between nominal bonds and inflation linked bonds of the same issuer with the same maturity.

In order to adjust for inflation, one should always use those break even rates, as they are the best (and actually traded) proxies for inflation. Let’s look quickly at German Break even rates:

DEGGBE10 Index (Germany Breakeve 2014-01-27 11-34-09

So we can see that currently, the break even rate is very close to the actual assumed inflation rates for Thyssenkrupp and we do not need to adjust for this. However, when inflation rates would go up, we would need to adjust and the impact can be huge. For further information about inflation linked bonds, there is a lot of stuff available, for instance here.

Deflation put

There is however one “small” problem with the approach above: The price difference between inflation linked bonds and nominal bonds includes the scenario of deflation. Normal, EUR based inflation linked bonds will have a floor at 0% inflation, i.e. they don’t loose nominal value in a deflation scenario. German pension plans however have a floor at +1% inflation. If I would compare a German Inflation linked bond with a floor at 0% and one with a floor at 1%, the one with the 1% floor is clearly more valuable, which means that this put granted to the retirees is definitely worth something. Modelling inflation linked options is quite complex, so as a proxy I would use maybe a 2-3% top up for German pension plans in order to reflect this 1% “floor” granted to the retirees.

Common myth: Inflation component is not important as profits of the company and or nominal interest rates will increase with inflation

This is an argument I often hear: You don’t need to care about the inflation in pension liabilities, as the profit of the company will increase with inflation. A second argument is that if inlfation increases, interest rates will automatically go up and thus, offsetting the increase. Let’s tackle the issues one after another:

Company profits and inflation
Honestly, I think not many of us do really know how a period of increasing inflation looks like. In Germany for instance, the inflation rate was between 0-2% p.a. for the last 20 years, a real increase in inflation was experienced the last time around the date of the reunification in the late 80ties and early 90ties as this chart shows:

It should be clear from the past that not all company can simply pass inflation to customers and maintain (or even grow) profits. In my opinion, especially those companies with large pension liabilities have vulnerable business models, especially capital-intensive companies like Thyssen and Lufthansa. Software Companies like SAP for instance will be able to pass most of their cost increases to customers, but they don’t have an issue with pension liabilities anyway. Especially vulnerable in my opinion are utilities, where power prices in inflationary periods are often capped by regulators, whereas input costs often rise quickly

Inflation and interest rates

In the past, high inflation risks often went along with high interest rates, especially in the 70ties and 80ties. The relationship was mostly: Inflation spiked and central banks then had to increase interest rates in order to reduce economic activity and get inflation under control. This time however it might be different. Central banks all over the world have made it clear that the want higher inflation AND low interest rates in order to lower Sovereign debt burdens. It is not clear if they do achieve this, but I think it is also optimistic to assume automatically higher interest rates in the future if inflation picks up.

Quantifying inflation risk pragmatically:

If we look at all the points above, it should be clear that having a liability which will increase with increasing inflation is worse than having for instance a senior bond liability with fixed payments. Even if we use and adjust for current break even rates, there is always the risk that inflation increases above that, especially now, with the Central banks clearly targeting higher levels. As we have seen above, companies with a very strong competitive position and low capital intensity, we can assume that they will be able to earn their margins even under increased inflation. A company which is very asset intensive (i.e. depreciation will be too low in an inflationary scenario), will however get a “double whammy” via increasing pension liabilities.

My proposal to quantify inflation risk would be the following:

– company where inflation has no impact (or even positive) on profit: No adjustment necessary
– company where inflation impact is unclear: 5%-10% “risk adjustment”
– company where inflation impacts business negatively: 10%-20% “risk adjustment”

Those adjustments are very rough proxies for the amounts which would be calculated by a fully fledged risk model but I think as a rough indication this is better than nothing.


So summing it up: In order to reflect inflation risks in a typical inflation linked DBO pension plan correctly, one should make the following adjustments for a prudent valuation:

1. Check if assumed inflation rate is close to relevant “Break even” inflation rates implied in traded inflation linked bonds. If not adjust with the difference multiplied with duration.
2. If there is a minimum inflation “guarantee”, further adjust with a 2-3% upwards adjustment for the liability
3. Determine if the underlying business is negatively effected from inflation. In doubt, use a 5%-10% mark up, if there is a clear negative relationship, use a 10%-20% mark up to reflect the uncertainty compared to a fixed liability

Again, I know that this are very rough proxies and you don’t need to do that. But for a prudent valuation, especially for companies with large pension liabilities, it would be very optimistic not to make adjustemnts for inflation risk.

“Risk free” rates and discount rates for DCF models

In the discussion to the Piquadro valuation, I quickly mentioned that the concept of “risk free” rates is a difficult concept at the moment.

Let’s have a quick look at the “academical” world:


If we look at the CAPM (no matter if one beliefs this or not) we can see that the risk free rate of return plays an important role there. First, it is the basis return on needs to achieve with any investment, secondly it also influences the equity risk premium.

Risk free rate of return

The definition of the risk free rate itself is quite “fishy”. Investopedia for example states:

Investopedia explains ‘Risk-Free Rate Of Return’
In theory, the risk-free rate is the minimum return an investor expects for any investment because he or she will not accept additional risk unless the potential rate of return is greater than the risk-free rate.

In practice, however, the risk-free rate does not exist because even the safest investments carry a very small amount of risk. Thus, the interest rate on a three-month U.S. Treasury bill is often used as the risk-free rate.

This is of course not really applicable for any serious long term investor. Damodaran has a nice paper about “risk free rates” here.

His major points are as follows:

The first is that there can be no default risk. Essentially, this rules out any security issued by a private firm, since even the largest and safest firms have some measure of default risk. The only securities that have a chance of being risk free are government securities, not because governments are better run than corporations, but because they control the printing of currency. At least in nominal terms, they should be able to fulfill their promises. Even this assumption, straightforward though it might seem, does not always hold up, especially when governments refuse to honor claims made by previous regimes and when they borrow in currencies other than their own.

So this is important: No default risk !!! So it is wrong for instance to use current yields of Italian Govies for valueing Italian stocks, as considerable default risk is embedded in current spreads. The “country” risk could/should be embedded into the equity risk premium, not into the risk free rate. A hypothetical Italian company with 100% of its business in Germany for example, should only get a very small country risk charge if any.

A second point is the following:

There is a second condition that riskless securities need to fulfill that is often forgotten. For an investment to have an actual return equal to its expected return, there can be no reinvestment risk.

In theory, one should discount annual cash flows with the respective annual risk free rates. With a flat yield curve, this is not so important but for steep yield curves the differences can be significant. However in practice Damodaran recommends using the duration of the cash flows of the analysed investment as proxy for the risk free rate. As the best proxy if we don’t want to do this, he recommends the 10 year rate.

For the EUR, he recommends specifically the following:

Since none of these governments technically control the Euro money supply, there is some default risk in all of them. However, the market clearly sees more default risk in the Greek and Portuguese government bonds than it does in the German and French issues. To get a riskfree rate in Euros, we use the lowest of the 10-year government Euro bond rates as the riskfree rate; in October 2008, the German 10-year Euro bond rate of 3.81% would then have been the riskfree rate.

With regards to currencies he says this:

Summarizing, the risk free rate used to come up with expected returns should be measured consistently with the cash flows are measured. Thus, if cash flows are estimated in nominal US dollar terms, the risk free rate will be the US Treasury bond rate. This will remain the case, whether the company being analyzed is a Brazilian, Indian or Russian company. While this may seem illogical, given the higher risk in these countries, the riskfree rate is not the vehicle for conveying concerns about this risk. This also implies that it is not where a project or firm is domiciled that determines the choice of a risk free rate, but the currency in which the cash flows on the project or firm are estimated.

The most common mistake with currencies is usually to use current exchange rates for future cashflows which then results in a preference for projects in countires wiht high nomnal rates.

About Inflation, he is not really clear in my opinion. He argues basically, inflation does not matter because we get the same result if we use yields of inlfation linked bonds combined with inflation adjusted growth rates.

Especially the current situation, where we see negative real yields in many markets, one could argue about his appoach. A negative real yield means for an investor, that the “risk free” nominal asset would have a guaranteed loss in real purchasing power over the investement horizon.

Consider for instance the UK: 10 year gilts run at 2.158% yield, this would be the proxy for the risk free rate. Current inflation runs at 5%, UK 10 year implied inflation from inflation linked bonds is around 3%.

So if I would use the 10 year gilt as proxy as the risk free rate, I woul dalready accept a loss of -1% p.a. in real terms p.a. or almost -3% p.a. based on current inflation rates.

I think this topic might justify even a doctorate thesis, but in my opinion, one could go the following pragamatic way:

Proxy for risk free rate: Higher of 10 year risk free Govie Yield in currency or inflation ).

So in the case of the risk free rate for an Italian company I would compare:

a) 10 year risk free EUR rate = 10 year bunds = 1.89%
b) Inflation: Currently =3.4%

I would the use the higher of the two rates, 3.4 %. This would be a pragmatic way to avoid unnecessary country risk premium and still make sure, the risk free rate does not imply a guaranteed loss in real terms.