Contractually linked instruments

Contractually linked instruments – IFRS 9 provides specific guidance for circumstances in which an entity prioritises payments to the holders of multiple contractually linked instruments that create concentrations of credit risk – i.e. tranches. The right to payments on more junior tranches depends on the issuer generating sufficient cash flows to pay more senior tranches. The standard requires a look-through approach to determine whether the SPPI test is met. [IFRS 9 B4.1.20–26]

The following flow chart illustrates how an entity determines whether a tranche meets the SPPI test. [IFRS 9 B4.1.21, IFRS 9 B4.1.23–25]

Contractually linked instruments

In performing the assessment of financial instruments in the underlying pool, a detailed instrument-by- instrument analysis of the pool may not be necessary. However, an entity has to use judgement and perform sufficient analysis to determine whether the SPPI test is met. In performing the analysis, an entity also considers IFRS 9’s guidance on de-minimis or non-genuine features. [IFRS 9 B4.1.25] Contractually linked instruments

The look-through approach is carried through to the underlying pool of instruments that create, rather than pass through, the cash flows. For example, if an entity invests in contractually linked notes issued by a special purpose entity SPE 1, whose only asset is an investment in contractually linked notes issued by SPE 2, then the entity looks through to the assets of SPE 2 in performing the assessment. [IFRS 9 B4.1.22] Contractually linked instruments

If an entity is not able to make an assessment based on the above criteria, then it measures its investment in the tranche at FVPL. [IFRS 9 B4.1.26]

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Company W, a limited-purpose entity, has issued two tranches of debt that are contractually linked. The Class I tranche amounts to 15 and the Class II tranche amounts to 10. Class II is subordinate to Class I, and receives distributions only after payments have been made to the holders of Class I. W’s assets are a fixed pool of loans of 25, all of which meet the SPPI test.

Investor X has invested in Class I. X determines that, without looking through the underlying pool, the contractual terms of the tranche give rise only to payments of principal and interest.

X then has to look through to the underlying pool of investments of W. Because W has invested in loans that meet the SPPI test, the pool contains at least one instrument with cash flows that are solely principal and interest. W has no other financial instruments, and is not permitted to acquire any other financial instruments. Therefore, the underlying pool of financial instruments held by W does not have features that would prohibit the tranche from meeting the SPPI test. Contractually linked instruments

The last step in the analysis is for X to assess whether the exposure to credit risk inherent in the tranche is equal to or lower than the exposure to credit risk of the underlying pool of financial instruments. Because the Class I notes are the most senior tranche, the credit rating of the tranche is higher than the weighted-average credit rating of the underlying pool of loans. Accordingly, X concludes that Class I meets the SPPI test. Contractually linked instruments

Investor Y has invested in Class II. This tranche is the most junior tranche and does not meet the credit risk criterion. Therefore, Investor Y measures any investment in Class II at FVPL.

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In some cases, the financial assets in the pool may be collateralised by assets that would not themselves meet the SPPI test – e.g. loans secured against real estate or equity instruments – and, if the debtor defaults, then the issuer may take possession of that collateral. The new standard clarifies that this ability to take possession of such assets is disregarded when assessing whether the tranche satisfies the SPPI test, unless the entity acquired the tranche with the intention of controlling the collateral. [IFRS 9 B4.1.26]

The underlying pool may include derivative instruments that align the cash flows of a tranche with the cash flows of the underlying instruments, or that reduce cash flow variability. The allocation of gains and losses that arise from market risk on derivative instruments in the pool may be relevant in determining whether the contractual terms of a tranche itself give rise to cash flows that are solely payments of principal and interest. For example, if the cash flows from an interest rate swap included in the pool were allocated to a tranche to provide investors in the tranche with a return based on two-times LIBOR, then the tranche would not meet the SPPI test. [IFRS 9 B4.1.24(a)]

Changes in the underlying pool

When a pool includes more than one derivative instrument, it appears that an entity is able to combine derivatives when performing the assessment described in condition (b) in the flowchart above if the combined derivative would give the same result as if a single derivative had been included in the portfolio.

Something else -   Changes in contractual provisions

Example: Derivatives in the underlying pool Contractually linked instruments

An SPE has a portfolio of variable interest rate financial assets denominated in euro. It issues tranches of fixed-rate contractually linked notes denominated in US dollars. The SPE enters into two derivatives:

  • a pay-variable-euro, receive-variable-US-dollar swap; and Contractually linked instruments
  • a pay-variable-US-dollar, receive-fixed-US-dollar swap. Contractually linked instruments

In this case, the combination of these two swaps is equivalent to one cross-currency interest rate swap to pay variable euro and receive fixed US dollars – i.e. the receive leg of the first swap offsets the pay leg of the second swap. In this scenario, the holder of an investment in the notes could combine the two derivatives and assess them in combination, rather than performing an individual assessment for each derivative.

Derivatives in pools of assets

The pool of underlying instruments and their cash flows may change as a result of prepayments or credit losses, and by any permitted extinguishments or transfers. It appears that, for the SPPI test to be met, the terms of the contractually linked structure should include a mechanism designed to ensure that the amount of any derivatives is reduced in response to any such events, so that the derivatives do not fail to meet the cash flow variability or alignment tests. For example, an interest rate swap may contain a clause under which the notional amount is automatically reduced to match any declines in the principal amount of performing assets within an underlying pool.

Contractually linked instruments

Contractually linked instruments

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Contractually linked instruments Contractually linked instruments Contractually linked instruments Contractually linked instruments Contractually linked instruments

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