Chapter 5 — Common Embedded Features Unique to Debt Host Contracts

5.3 Credit-Risk-Related Features Embeddded in a Debt Host

5.3 Credit-Risk-Related Features Embedded in a Debt Host

5.3.1 Background

Examples of contractual provisions in debt contracts that could adjust payments on the basis of a measure of credit risk include:

A provision that requires the debtor to pay additional interest (e.g., 2 percent per annum) upon the debtor’s event of default.
A feature that adjusts interest payments on the basis of a measure of the debtor’s creditworthiness (e.g., a table that specifies different margins over a specified interest rate on the basis of a measure of the debtor’s working capital).
A feature that adjusts principal or interest payments on the basis of the credit risk of a third party.

This section does not address features that could accelerate the repayment of the outstanding amount of the debt host contract in cash upon the occurrence or nonoccurrence of a specified event such as an event of default. Such features should be evaluated as contingent redemption features (see Section 6.4).

5.3.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of a credit-risk-related feature embedded in a debt host contract. However, an entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 4.3.2)	It depends	A credit-sensitive payment that is based solely on the creditworthiness of the debtor is clearly and closely related to a debt host. However, the creditworthiness of a third party is not clearly and closely related to a debt host.
Hybrid instrument not measured at fair value through earnings on a recurring basis (see Section 4.3.3)	It depends	From the issuer’s perspective, debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10. The fair value option cannot be elected for debt that contains a separately recognized equity component at inception. From the holder’s perspective, if a loan or debt security is remeasured at fair value, with changes in fair value recorded in earnings, any derivative embedded in the interest would not need to be accounted for separately since the accounting for the interest would already be the same as that of a freestanding derivative.
Meets the definition of a derivative (see Section 4.3.4)	Yes	A credit-risk-related feature that adjusts the payments of a debt host contract meets the definition of a derivative.
Meets a scope exception (see Chapter 2 and Section 4.3.5)	It depends	Typically, no specific scope exception is available for a credit-risk-related feature that is based on the debtor’s creditworthiness(see Section 4.3.5). However, in some situations the scope exception for financial guarantee contracts may apply (see Section 2.3.4).

As shown in the table above, an entity’s determination of whether an embedded credit-risk-related feature must be bifurcated as a derivative tends to focus on whether the feature is considered clearly and closely related to the debt host contract (see the next section) unless the entity is remeasuring the hybrid instrument at fair value on a recurring basis through earnings. If the credit-risk-related feature is based on the credit risk of a third party, the entity should also evaluate whether the feature can be net settled (see Section 5.3.4) and whether it qualifies for the scope exception for financial guarantee contracts (see Section 2.3.4).

5.3.3 Clearly-and-Closely-Related Analysis

ASC 815-15

25-46 The creditworthiness of the debtor and the interest rate on a debt instrument shall be considered to be clearly and closely related. Thus, for debt instruments that have the interest rate reset in the event of any of the following conditions, the related embedded derivative shall not be separated from the host contract:

Default (such as violation of a credit-risk-related covenant)
A change in the debtor’s published credit rating
A change in the debtor’s creditworthiness indicated by a change in its spread over U.S. Treasury bonds.

25-47 If an instrument incorporates a credit risk exposure that is different from the risk exposure arising from the creditworthiness of the obligor under that instrument, such that the value of the instrument is affected by an event of default or a change in creditworthiness of a third party (that is, an entity that is not the obligor), then the economic characteristics and risks of the embedded credit derivative are not clearly and closely related to the economic characteristics and risks of the host contract, even though the obligor may own securities issued by that third party. This guidance shall be applied to all other arrangements that incorporate credit risk exposures that are unrelated or only partially related to the creditworthiness of the issuer of that instrument. This guidance does not affect the accounting for a nonrecourse debt arrangement (that is, a debt arrangement in which, in the event that the debtor does not make the payments due under the loan, the creditor has recourse solely to the specified property pledged as collateral).

A credit-sensitive payment is considered clearly and closely related to a debt host contract under ASC 815-15-25-46 and 25-47 if it is triggered by, and directionally consistent with, a measure of the debtor’s creditworthiness, such as one or more of the following:

The debtor’s failure to pay amounts due on a timely basis (e.g., additional interest on late payments).
The debtor’s failure to comply with credit-risk-related debt covenants (e.g., additional interest that becomes payable if there is a material adverse change in the debtor’s creditworthiness).
A change in the debtor’s published credit rating (e.g., additional interest that becomes payable upon a credit rating downgrade).
A change in observable interest rate spreads over a risk-free interest rate (e.g., U.S. Treasury rates) for debt instruments with similar credit risk (e.g., an interest rate that varies on the basis of observable credit spreads on identical or similar debt securities issued by the debtor or other similar debtors).
A change in another measure of the debtor’s creditworthiness (e.g., a specified interest margin that varies on the basis of a measure of the debtor’s working capital).

However, a provision that requires an adjustment on the basis of the creditworthiness of a third party (e.g., the third party’s default) is not clearly and closely related to a debt host contract.

Debt contracts often contain provisions that require the debtor to pay additional interest upon the occurrence of an “event of default.” To determine whether such a provision is clearly and closely related to the debt host, the entity must evaluate how the debt terms define an event of default. The table below discusses common situations that may be described as events of default and whether such triggering events would be considered clearly and closely related to a debt host.

Triggering Event	Clearly and Closely Related?
Any representation or warranty made by the debtor is not correct	Yes
The debtor’s failure to perform or comply with financial or nonfinancial covenants	Yes, unless the covenants include items that do not affect the issuer’s credit risk
The debtor’s bankruptcy or insolvency	Yes
Cross default on the debtor’s other indebtedness	Yes, unless the default on the other indebtedness arises from events that are not credit-related
Invalidity or failure of debtor to maintain loan or collateral documents	Yes
The debtor’s nonpayment of principal or interest when due	Yes
Judgments or orders against the debtor exceeding a specific amount	Yes
Revocation of the debtor’s license or permit to perform business operations that results in a material adverse effect	Yes
Criminal events of the debtor	Yes
A change of control of the debtor	No
Key-person event	Depends on facts and circumstances
The debtor suffers a credit rating downgrade	Yes
An observable increase in the debtor’s current interest rate spread over a risk-free interest rate	Yes

Example 5-8

Debt With Interest Rate Adjustment

Company ABC, which is rated BBB, issues $100 million in 8 percent fixed-rate bonds. The bonds include a provision that requires the interest rate to reset to 10 percent if ABC’s credit rating is downgraded to a single B at any time during the term of the bonds. The embedded derivative that resets the interest rate of the bonds is clearly and closely related to the debt host because it is based on the issuer’s credit rating.

However, if ABC’s bonds include a provision that requires the interest rate to reset to 10 percent if Company XYZ’s (an unrelated party’s) credit rating is downgraded to a single B at any time during the term of the bonds, the reset feature is not clearly and closely related to the debt host.

ASC 815-15

Case A: Credit-Linked Note

55-103 Entity A issues to an investor a fixed-rate, 10-year, $10 million credit-linked note that provides for periodic interest payments and the repayment of principal at maturity. However, upon default of a specified reference security (an Entity X subordinated debt obligation) the redemption value of the note may be zero or there may be some claim to the recovery value of the reference security (depending on the terms of the specific arrangement). Generally, the term reference security refers to the security whose credit rating or default determines the cash flows under a credit derivative. Usually, the terms of credit-linked notes explicitly reference Committee on Uniform Security Identification Procedures (CUSIP) numbers of securities in the marketplace. In an event of default of the specified reference security, there is no recourse to the general credit of the obligor (Entity A). In exchange for accepting the default risk of the reference security, the note entitles the investor to an enhanced yield. The transaction results in the investor selling credit protection and Entity A buying credit protection.

55-104 The credit-linked note includes an embedded credit derivative. The credit risk exposure of the reference security (Entity X) and the risk exposure arising from the creditworthiness of the obligor (Entity A) are not clearly and closely related. Thus, the economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the debt host contract and, accordingly, the criterion in paragraph 815-15-25-1(a) is met.

55-105 Paragraph 815-15-25-6 explains that the fair value election for hybrid financial instruments that otherwise would require bifurcation does not apply to hybrid financial instruments that are described in paragraph 825-10-50-8, which include insurance contracts as discussed in Section 944-20-15, other than financial guarantees and investment contracts.

55-106 Consideration should be given to whether the embedded derivative could possibly not be subject to this Topic as a financial guarantee under paragraph 815-10-15-58 and, in that circumstance, the embedded derivative would not warrant bifurcation.

Case M: Credit-Sensitive Bond

55-200 A credit-sensitive bond has a coupon rate of interest that resets based on changes in the issuer’s credit rating.

55-201 A credit-sensitive bond can be viewed as combining a fixed-rate bond with a conditional exchange contract (or option contract) that entitles the investor to a higher rate of interest if the credit rating of the issuer declines. Because the creditworthiness of the debtor and the interest rate on a debt instrument are clearly and closely related, the embedded derivative should not be separated from the host contract.

Example 5-9

EBITDA-Indexed Rate Reset Provision

Company A issues term loans of $150 million, which pay a floating rate of interest. The floating interest rate is adjusted quarterly and is based on an interest rate index plus a spread over the interest rate index. At each interest repricing date, A may elect to choose bank prime or SOFR as the interest rate index. The spread above the interest rate index is based on A’s debt to EBITDA ratio at the end of the most recent quarter.

As A pays down or issues debt and its operating income increases or decreases from the previous period, the overall interest rate payments fluctuate. The spread above the interest rate index on A’s debt fluctuates on the basis of A’s operating income and outstanding debt balance. The economic characteristics of these terms may be determined to be directly related to A’s creditworthiness and, in such case, would be clearly and closely related to the debt host.

If, however, it is determined that the terms were not directly related to A’s creditworthiness, they would not be considered clearly and closely related to the debt host, and there may be an embedded derivative that should be accounted for. For example, if the spread above the interest rate index increased as EBITDA increased, the feature related to EBITDA would not be directly related to the debtor’s creditworthiness and, therefore, would not be considered to be clearly and closely related to the debt host.

5.3.4 Derivative Analysis

The table below presents an analysis of whether a credit-risk-related embedded feature that could adjust the payments on a debt host contract meets the definition of a derivative (see Section 4.3.4). However, an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 1.4.1)	Yes	A credit-risk-related feature that could adjust the payments of a debt host contract generally has both an underlying (e.g., an event of default or the issuer’s credit rating) and a notional amount (i.e., the amount on which the adjustment is based, such as the debt’s outstanding amount) or payment provision (e.g., a fixed cash payment).
Initial net investment (see Section 1.4.2)	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the credit-risk-related feature on a stand-alone basis without the host contract). Generally, a credit-risk-related feature has an initial net investment that is smaller than would be required for a direct investment that has the same exposure to changes in credit risk (since the investment in the debt host contract does not form part of the initial net investment for the embedded feature).
Net settlement (see Section 1.4.3)	Yes	A credit-risk-related embedded feature that adjusts the payments of a debt host contract meets the net settlement condition (neither party is required to deliver an asset that is associated with the underlying and whose principal amount, stated amount, face value, number of shares, or other denomination is equal to the feature’s notional amount).

As shown in the table above, a credit-risk-related embedded feature that could adjust the payments of a debt host contract on the basis of the debtor’s creditworthiness meets the definition of a derivative. Therefore, the analysis of whether such a feature must be bifurcated as a derivative tends to focus on whether the feature is considered clearly and closely related to the debt host contract unless the entity is remeasuring the hybrid instrument at fair value on a recurring basis through earnings.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.