5.2 Features Related to an Interest Rate Embedded in a Debt Host

Company X invests in a $10 million 10-year bond that pays a fixed rate of 6 percent for the first two years and then pays a variable rate calculated as 14 percent minus the product of 2.5 times three-month SOFR, without a floor, for the remaining term of the bond.

Company X makes this investment as part of the initial issuance of the bond and must perform the negative-yield test as of the initial recognition date, the same date on which the bond issuer performs the test. Company X and the issuer should reach the same conclusion when applying the negative-yield test.

If three-month SOFR were to increase significantly, the bond might have a negative return, which would effectively erode the bond’s principal. Because there is a possibility that X may not recover substantially all of its initial investment, the negative yield test is passed. Company X and the bond issuer should, therefore, separately account for the embedded interest rate derivative unless the entire hybrid financial instrument is recognized at fair value, with changes in fair value recognized in earnings.

A securitization vehicle (i.e., an SPE) holds prepayable fixed-rate mortgage loans with a principal amount of $100,000 and issues variable-rate notes (beneficial interests) with a principal amount of $100,000 to investors. Concurrently with issuing its beneficial interests, the SPE enters into a pay-fixed, receive-variable interest rate swap with a third party. The notional amount of the swap declines according to a planned amortization schedule to approximate prepayment forecasts for the underlying loans as of the securitization date. A good-faith estimate was used to develop the planned amortization schedule; this estimate was reasonable given the facts and circumstances that existed at hedge inception.

To assess the negative-yield test in ASC 815-15-25-26(a), a holder of a variable-rate note must consider whether the note can contractually be settled in such a way that the holder would not recover substantially all of its initial recorded investment in the note. In doing so, it must consider all possible interest rate scenarios, even those that are considered remote. In this example, an unexpected decline in interest rates could cause the fixed-rate loans held by the SPE to be prepaid at a faster rate than had been expected as of the securitization date. Because the notional amount of the interest rate swap amortizes according to the original prepayment expectations, the unexpected loan prepayments could cause the notional amount of the swap to exceed the outstanding principal amount of the underlying loans.

If, for example, the swap contract requires the SPE to make net payments to the swap counterparty because of a decline in interest rates, the cash flows generated by fixed-rate loans remaining in the SPE may not be sufficient for the SPE to make payments to the counterparty and pay off the principal on the outstanding notes. In this scenario, it is possible that the investor would not recover substantially all of its initial recorded investment in its notes; accordingly, the notes would pass the negative-yield test and the holder of the variable-rate notes would conclude that the notes contain an embedded derivative that is not clearly and closely related to the host.

The holder then would have to assess whether the embedded derivative satisfies the remaining conditions of ASC 815-15-25-1 to determine whether the embedded derivative needs to be bifurcated from its host.

Company A invests in 30-year variable-rate debt issued by Company B. The debt is indexed to the three-month SOFR rate plus 4 percent. As of the date of issuance, the three-month SOFR rate was 2 percent. The debt’s terms also specify that if the three-month SOFR rate increases to 5 percent, the debt issuer is required to pay 23 percent for the remaining term of the bonds.

Company A makes its investment as part of the initial issuance of B’s variable-rate debt. Accordingly, both A and B would perform the double-double test as of the same date and should reach the same conclusion.

If B were to issue 30-year variable-rate debt without any embedded derivatives (i.e., the interest rate reset feature), it would pay a coupon of three-month SOFR plus 6 percent. Consequently, the initial rate of return on the host contract is 8 percent (three-month SOFR of 2 percent plus 6 percent). Company A must determine whether the embedded derivative could at least double its initial rate of return on the host contract, which was 8 percent as of the issuance date, in any of the possible interest rate environments. When three-month SOFR increases to 5 percent, the 23 percent interest rate feature more than doubles the initial rate of return of 8 percent on the host contract; therefore, step 1 of the double-double test is satisfied.

To apply step 2 of the double-double test, A must determine whether, for any of the possible interest rate scenarios under which its initial rate of return on the host contract would be doubled (i.e., when three-month SOFR is at 5 percent or higher), the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return on a contract with the same terms as the host contract. When three-month SOFR increases to 5 percent, the rate of return on a contract with the same terms as the host contract (and involving a debtor with a credit quality similar to B’s credit quality at debt inception) would be 11 percent (three-month SOFR of 5 percent plus 6 percent). Therefore, step 2 of the double-double test is also satisfied because when three-month SOFR increases to 5 percent, the 23 percent return generated by the embedded derivative feature in the debt is more than twice the 11 percent return (three-month SOFR of 5 percent plus 6 percent) on the contract with the same terms as the host contract.

Both A and B would be required to account for the embedded derivative separately unless the entire hybrid financial instrument is recognized at fair value, with changes in fair value recognized in earnings. Note that ASC 815-15-25-26 indicates that when an entity assesses whether it meets one of the conditions, it should not consider the probability that the condition will be satisfied; the condition should be considered satisfied if there is any possibility whatsoever that the condition will be met. Therefore, the probability that the three-month SOFR rate will increase to 5 percent or higher is not relevant to the analysis of whether the condition is met. However, an entity should consider such probability when valuing any bifurcated embedded derivative.

Company A issues five-year variable-rate debt to the public that is indexed to the SOFR rate (SOFR plus 1 percent). SOFR is currently 6 percent. The investors required that A pay not less than 5 percent at any time during the term of the debt. The agreement that A will not pay an interest rate less than 5 percent on its variable-rate debt represents a floor. If A had issued five-year variable-rate debt without a floor, it would have paid SOFR plus 2 percent.

The floor would not pass the negative-yield test (ASC 815-15-25-26(a)) because it could not result in a failure of the investor to recover substantially all of its initial investment. In addition, the floor would not pass the double-double test (ASC-815-25-26(b)) because it could not result in a rate of return that is more than double the initial rate of return of 8 percent (SOFR at inception plus 2 percent). The floor, when in-the-money, will only result in a rate of 5 percent.

On January 1, 20X1, Company X purchases a bond at par that pays SOFR. The bond also incorporates an interest rate cap provision under which if SOFR equals or exceeds 8 percent as of any interest rate reset date, X will receive a return of 10 percent. On the date on which X purchased the bond, it also could have purchased at par a variable-rate bond not containing a cap that pays SOFR minus 1 percent from a debtor that has the same credit quality as the issuer of X’s bond. As of January 1, 20X1, SOFR is 5 percent.

Since the bond containing the cap cannot contractually be settled such that X would not recover substantially all of its initial recorded investment in the bond, the negative-yield test in ASC 815-15-25-26(a) is not passed. To perform the first step of the double-double test (ASC 815-15-25-26(b)), X must determine whether there are any interest rate scenarios, no matter how remote, under which the embedded derivative (the cap) would at least double its initial rate of return on the host contract. This analysis is summarized in the following table:

Since the first step suggests that there is a possible scenario in which X could double its initial rate of return on the host contract, X must perform the second step in ASC 815-15-25-26(b) to determine whether the embedded cap is clearly and closely related to the debt host contract. For this test, X must determine, for any of the possible interest rate scenarios identified above under which X’s initial rate of return on the host contract would be doubled, whether the embedded cap would simultaneously result in a rate of return that is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that (1) has the same terms as the host contract and (2) involves a debtor with a credit quality similar to the issuer’s credit quality at inception. Company X’s analysis for this test can be summarized as follows:

Since the second step suggests that there is no possible scenario in which the investor would achieve a rate of return that is at least twice what otherwise would be the then-current market return, the double-double test in ASC 815-15-25-26(b) is not passed, and the embedded cap is considered clearly and closely related to the debt host contract.

On January 1, 20X0, an entity issues a variable-rate debt instrument at par, maturing on January 1, 20X5. The interest rate is three-month SOFR plus 0.40 percent as long as three-month SOFR remains at or above 6.00 percent. In periods in which three-month SOFR drops below 6.00 percent, the interest rate on the debt is calculated as follows: three-month SOFR plus 0.40 percent – [2 × (6.00% – 3-month SOFR)]. The following table illustrates the interest rate on the debt under certain conditions:

For the embedded derivative to be considered clearly and closely related to the debt host, it must not be contractually possible for the hybrid instrument to be settled in such a way that the investor would not recover substantially all of its initial recorded investment. In this example, it is possible for the investor in the debt to incur an unlimited negative return, thus not recovering substantially all of its original investment. Therefore, the negative-yield test in ASC 815-15-25-26(a) is passed, and the embedded floor would not be considered clearly and closely related to the debt host.

By contrast, assume that the agreement contained a provision that guaranteed a cumulative minimum rate of return to the investor over the life of the debt. For example, the agreement could contain a minimum interest rate clause such that negative interest accrues if the defined interest rate is less than zero; however, the accrued negative interest could only be applied to (1) future interest payments required under this debt or (2) the principal amount only to the extent of interest previously paid under the debt agreement, provided that any accrued interest remains at the debt’s maturity. In this scenario, the instrument could not contractually be settled in such a way that the investor would not recover substantially all of its initial recorded investment. Therefore, the negative-yield test in ASC 815-15-25-26(a) would not be passed, and the leveraged interest rate terms and floor would be considered clearly and closely related to the debt (provided that under ASC 815-15-25-26(b)’s double-double test, those embedded features are clearly and closely related to the debt host). A cap on a leveraged interest rate index would be similarly analyzed under ASC 815-15-25-26 through 25-29.

Assume that a 30-year note has an initial yield of 4 percent and that the contractual interest rate resets semiannually to a 10-year index interest rate plus 100 basis points rather than to the six-month rate. The initial yield on a security that resets to the six-month rate, but that otherwise has terms that are identical to those of the 30-year note, is 3 percent.

Because the interest rate resets semiannually to a point further out than the next reset date on the interest rate curve (i.e., a 10-year rate versus a six-month rate), there are possible future interest rate scenarios under which the initial rate of return on the host contract and the then-current market rate would be doubled. The application of the double-double test (ASC 815-15-25-26(b)) is shown in the table below.

Because both conditions of the double-double test in ASC 815-15-25-26(b) are met, the embedded interest rate index is not considered clearly and closely related to the debt host of the 30-year note. If the instrument contains a cap that is less than double the initial rate of return on the host contract, however, the conditions in ASC 815-15-25-26(b) would not be met.