In continuation of previous articles on “Double-double test, Caps & Floor, Call/Put/ Prepayments & Foreign Currency Bonds – Embedded Derivatives as per Ind-As/ IFRS”, using credit derivatives as one of the option embedded in a Host debt contract are quite common in international debt market by which credit risks associated with any debt Instrument is managed. Such reference of credit risk might be based on the same debt instrument or based on some third party Instrument.
Let’s first Understand the meaning of Credit Derivative and its nature / purpose for which it is being used in modern financial market –
In finance, a credit derivative refers to any one of “various instruments and techniques designed to separate and then transfer the credit risk“ or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender or debtholder.
It essentially means that a party can transfer credit risk associated with any of its asset in which the party invested to some third party at a specific price. This will ensure to get a cover from any default which might happen from the issuer of such debt.
Ind-As 109– Financial Instrument talks about specifically on Credit Derivatives where it will not be considered closely related.
Standards objective was to provide a guidance which could be applicable to all such type of options mentioned in any debt instrument and accordingly separation will not be required to avoid any conflict in accounting.
Let’s have a quick reference of the standard which talks about such Credit Derivative options within debt instrument and related guidances if separation is required-
Ind-As 109 – “Financial Instruments”
Para -B-4.3.5 (f)- Credit derivatives that are embedded in a host debt instrument and allow
one party (the ‘beneficiary’) to transfer the credit risk of a particular reference asset, which it may not own, to another party (the ‘guarantor’) are not closely related to the host debt instrument. Such credit derivatives allow the guarantor to assume the credit risk associated with the reference asset without directly owning it.
Let’s have a clarity about the concept first before we get into an example. Any debt Instrument will have Interest rate which defines its value and the Interest rate will be a FUNCTION OF Credit risk, Risk Free Interest Rate, Expected maturity & Liquidity risk. Hence EMBEDDED DERIVATIVES that effects yield of debt instrument due to change in these four factors will always considered as closely related.
For example there is a clause in debt Instrument which says that Interest rate will be changed for the Host debt when there is deterioration in Credit risk of the party in a contract and a re-set in Interest rate will happen. Then this clause will be Inherent part of any debt instrument (as explained above) and hence will always be closely related. On the other hand if the credit risk adjustment is related to the assets which are based on third party (as the standard mentioned in its para B.4.3.5(f ) will NOT BE CLOSELY RELATED. Care should be taken while dealing such credit derivatives.
Let’s take an example to understand the overall objective of the standards and its related guidances –
An entity issues a Credit Linked Note (CLN) to Company A which is based on some third party portfolio of assets. The Credit linked note will comprise a fixed income security and a Credit derivative embedded in it .Whether these credit derivative will required to be separated?
Suggested approach –
Credit Linked Note will be a fixed income note which will comprise a series of payment and a credit risk which might change its value adversely in case the credit worthiness of the party deteriorates on which such credit linked note was issued.
No, because associated Credit Derivative is based on some third party Portfolio which is in line with the clause as mentioned in para B 4.3.5(f) of Ind-As 109. Hence a separation will be required for such Credit Derivative.
Readers will appreciate about the main objective of the standard and an approach which one can follow while keeping in mind the basis of origin of such requirements. There could possibly be some specific situations or circumstances where the interpretation of any standard will be different as we should always keep in mind that IND-AS is principle based standards and lot more areas need management judgment in line with the standards relevant interpretation and best practices.
One has to look into all related facts and patterns before concluding this type of assessment based on this concept. Readers are requested not to take this article as any kind of advice (it is not exhaustive in nature) and should evaluate all relevant factors of each individual cases separately.
(Author of this article is an experienced chartered accountant who has specialization on various GAAP conversions assignments covering different industries around different part of the world including acting as an Independent IFRS Advisor & Corporate Trainer. He can be reached via email at firstname.lastname@example.org or Whatsapp +91-9634706933)