The ECL requirements

The ECL requirements (Expected Credit Losses)  in IFRS 9 makes the initial selection of bonds for fixed income investments by financial institutions much more important, as selecting bonds with good long-term credit health is key to reducing the risk of future P&L fluctuations caused by changes in ECL. This is especially important for insurers that would like to adopt a buy-and maintain bond investment strategy. The ECL requirements

In an ideal world, the best action is to sell the bond prior to the start of its credit quality decline. Such early action will avoid P&L volatility due to the subsequent increase in ECL.

However, in practice, a bond may only come into focus after its credit quality has started to deteriorate, by which time the credit spread is likely to have already moved up and the price may have fallen significantly. At that point, trading out of the bond position will involve realizing a loss. Therefore, investors must accept a trade-off between suffering a current loss and the avoidance of a potentially larger P&L fluctuation in the future due to any ECL increase. The ECL requirements

The potential impact of the introduction of an ECL calculation on investment strategy can be illustrated by looking at bonds issued by Petrobras, the Brazilian oil group. Take, for example, “PETBRA 5.75% 20 January 2020”—a USD 2.5 billion 10-year senior unsecured bond issued by Petrobras with a 5.75% coupon on 30 October 2009. The ECL requirements

On 10 September 2015, Standard & Poor’s announced a double-notch downgrade for Petrobras, taking the company’s foreign currency long-term rating from BBB- to BB. This decision followed a downgrade to Brazil’s sovereign rating (Exhibit A). Following subsequent downgrades to Petrobras by Moody’s and Fitch, the company’s credit rating was deemed to be sub-investment grade by all three major rating agencies. As a result, the company’s bonds no longer qualified for certain investment grade bond indices. The ECL requirements

Exhibit A: Rating actions on PETBRA 5.75% 20 January 2020 by S&P and MOODY’SThe ECL requirements

The ECL requirements

Brazil spreads were 25-50 basis points wider after the country’s credit downgrade. However, Petrobras suffered more significant price falls and a greater widening in its yield spread following its downgrade (Exhibit B). The ECL requirements

Exhibit B: Option-adjusted spread for PETBRA 5.75% 20 January 2020

The ECL requirements

The downgrade by Moody’s on 29 January 2015 represented a critical decision point for investors. At this point, the bond was trading at about $95 per $100 notional, which was below its issuance price. It was still rated as investment grade, hence investors may still choose to rely on the “low credit risk1 definition under IFRS 9. In deciding whether to sell the bond, an investor would need to consider the tradeoff between the desire to avoid potential future P&L volatility caused by an increase in the ECL requirement, and the recognition of a realized loss on the immediate sale of the bond. The ECL requirements

During the financial crisis, the G20 tasked global accounting standard setters to work towards the objective of creating a single set of high-quality global standards. In response to this request, the IASB and FASB began to work together on the development of new financial instruments standards. The IASB decided to accelerate its project to replace IAS 39, and sub-divided it into three main phases: classification and measurement; impairment; and hedging. Macro hedging is being considered as a separate project. The ECL requirements

In November 2009, the IASB issued IFRS 9 (2009), the first milestone in the project to replace IAS 39. This standard required the classification and measurement of financial assets into only two categories: amortized cost, and fair value through profit or loss (“FVPL”).

In October 2010, the IASB published the updated IFRS 9 (2010), Financial instruments, to include guidance on financial liabilities and derecognition of financial instruments, and in particular the requirement to present changes in own credit risk on liabilities at fair value in other comprehensive income (“FVOCI”).

In March 2013, the IASB issued an exposure draft (ED) on limited amendments to IFRS 9 (2010), to address specific application questions raised by interested parties as well as to try and reduce differences with the FASB. However, the FASB tentatively decided that it would not continue to pursue a classification and measurement model similar to the IASB. As a consequence, the FASB’s classification and measurement project is expected to result in few changes to current US GAAP.

In November 2013, the IASB published the final hedging requirements excluding macro hedging.

In July 2014, the IASB published the new and complete version of IFRS 9 Financial Instruments, which includes the new hedge accounting, impairment and classification and measurement requirements.

The ECL requirements

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