Negative rates and embedded floors: a debt and hedge accounting headache

Following the 2008 global financial crisis, the inclusion of minimum rates of interest – aka embedded floors – in floating rate debt facilities became more prevalent. For some lenders, these were set at ‘non-zero’ levels in order to generate more return.

Since short-term rates started drifting towards zero and beyond in several of the world’s developed economies – such as those in the eurozone – lenders are incorporating zero percent floor clauses into all debt facilities. This feature has also spread into capital market loans and bond issuance, where investors who buy floating rate notes will not shoulder the burden of negative interest rates.

What seems logical from an economic and investment point of view, now represents an accounting challenge for many borrowers. Under financial reporting standard IAS 39 and its replacement IFRS 9, such a feature may be considered an embedded derivative that may have to be separately accounted for or bifurcated in the balance sheet of the borrower, and in some cases also the lender’s, at its fair value – simplistically, mark-to-market (M2M).

This is converse to US generally accepted accounting principles (GAAP) (ASC 815, the primary source of guidance on derivative instruments and hedging activities), where the requirement to bifurcate a similar feature is based on leverage criteria.

Under IAS 39 and similar standards, the criteria is whether the strike of the floor is in-the-money or not (i.e. when market rates are below the strike, which is the case for some currencies such as the euro (EUR), Swedish krona (SEK), Swiss franc (CHF) and Danish krone (DKK)). Changes in the fair value of the embedded derivative would be recorded into the income statement, potentially causing significant profit and loss (P&L) volatility as forward rates and option implied volatility change over the life of the instrument.

In practice, accountants and audit firms across various jurisdictions have markedly different interpretations of these accounting standards (i.e. whether the embedded floor should be bifurcated or not).

A growing attraction

As interest rates continue to fall, swaps are increasingly attractive instruments to use for hedging purposes. Many borrowers are keen to hedge the floating rate of their loans via a swap – in some cases even locking in negative swap rates. However, the inclusion of embedded floors in debt facilities is forcing treasurers to consider two issues:

1. How to deal with the P&L volatility arising from the embedded floor. If bifurcated, the embedded floor’s P&L impact can be offset by entering into an offsetting external derivative with a counterparty bank that mirrors the embedded floor in the loan. Careful consideration should be given to the terms of such an ‘external floor’ and whether the borrower should pay its premium cost upfront or embed its cost into the swap rate.

2. Potential P&L impact as hedge accounting ineffectiveness from entering into a swap. A borrower may enter into a fixed rate swap (pay fixed and receive floating) to hedge the cash flow interest risk of the floating rate liability. If the embedded floor is not bifurcated, for a swap to be a highly effective hedge accounting instrument it may have to include the zero floor. If the embedded floor is bifurcated, then a standalone swap, without an interest rate floor can be highly effective.

Negative rates might seem benign, but the accounting for bifurcated embedded floors and the associated consequences when trying to apply hedge accounting, merit treasurers’ and accountants’ full attention well before raising any new debt.

A thorough understanding of potential P&L impacts due to the bifurcation of the floor and cash flow hedge ineffectiveness will avoid surprises later on and help manage the expectations of key stakeholders such as chief financial officers (CFOs), the board of directors (BODs) and external auditors.

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