## A.6 Interest Rate Index Embedded in a Debt Host

Generally, interest rates are considered to be clearly and closely related to a
debt host. The guidance in ASC 815-15-25-26 addresses how an entity would assess two
conditions to determine whether an embedded derivative feature in a debt host in
which the only underlying is an interest rate or interest rate index (i.e., an
interest rate-related underlying) is not considered clearly and closely related to
the debt host. ASC 815-15-25-26 states:

For purposes of
applying the provisions of paragraph 815-15-25-1, an embedded derivative in
which the only underlying is an interest rate or interest rate index (such as an
interest rate cap or an interest rate collar) that alters net interest payments
that otherwise would be paid or received on an interest-bearing host contract
that is considered a debt instrument is considered to be clearly and closely
related to the host contract unless [one of two conditions exists.]

The first condition — ASC 815-15-25-26(a) — is as follows:

The hybrid instrument can contractually be settled in such a way that the investor (the holder or the creditor) would not recover substantially all of its initial recorded investment (that is, the embedded derivative contains a provision that permits any possibility whatsoever that the investor’s [the holder’s or the creditor’s] undiscounted net cash inflows over the life of the instrument would not recover substantially all of its initial recorded investment in the hybrid instrument under its contractual terms).

The term “substantially all” in ASC 815-15-25-26 is generally interpreted to mean that at least 90 percent of the original investment (i.e., the undiscounted net cash flows received by the investor over the life of the debt instrument would equal at least 90 percent of the investment balance initially recorded by the investor).

Example A-2

Bond With Leveraged Interest Rate Provision

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 the three-month LIBOR, without a floor, for the remaining term of the bond. If the three-month LIBOR were to increase significantly, the bond might have a negative return, which would effectively erode its principal. In that case, X might not recover substantially all of its initial investment. The issuer should therefore separately account for the embedded interest rate derivative unless it has elected the option in ASC 815-15-25-4 or ASC 825-10-25-1 to measure the entire hybrid financial instrument at fair value, with changes in fair value recognized in earnings.

The second condition — ASC 815-15-25-26(b) — is as follows:

The embedded derivative meets both of the following conditions:

- There is a possible future interest rate scenario (even though it may be remote) under which the embedded derivative would at least double the investor’s initial rate of return on the host contract (that is, the embedded derivative contains a provision that could under any possibility whatsoever at least double the investor’s initial rate of return on the host contract).
- For any of the possible interest rate scenarios under which the investor’s initial rate of return on the host contract would be doubled (as discussed in (b)(1)), 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 (under the relevant future interest rate scenario) for a contract that has the same terms as the host contract and that involves a debtor with a credit quality similar to the issuer’s credit quality at inception.

Note that ASC 815-15-25-37 states that the conditions in ASC 815-15-25-26(b)(1) and (b)(2) above do not apply to an embedded call option in a hybrid instrument that contains a debt host contract if the right to accelerate the settlement of the debt can be exercised only by the debtor (issuer/borrower).

Example A-3

Bond Indexed to LIBOR on Leveraged Basis

Company A invests in a 30-year variable-rate debt instrument issued by Company B. The instrument is indexed to the three-month LIBOR (3M LIBOR) plus 4 percent. As of the instrument’s issuance date, the 3M LIBOR was 2 percent. The instrument’s terms also specify that if the 3M LIBOR increases to 5 percent, the debt issuer is required to pay 23 percent for the remaining term of the bonds.

If B were to issue a 30-year variable-rate debt instrument without any embedded derivatives (i.e., the interest rate reset feature), it would pay a coupon of 3M LIBOR plus 6 percent. Consequently, the initial rate of return on the host contract is 8 percent (3M LIBOR 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 the 3M LIBOR increases to 5 percent, the 23 percent interest rate feature more than doubles the initial 8 percent rate of return on the host contract; therefore, the first condition (ASC 815-15-25-26(b)(1)) is satisfied.

To determine whether the second condition (ASC 815-15-25-26(b)(2)) is satisfied, A must assess 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 the 3M LIBOR is at 5 percent), 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 the 3M LIBOR increases to 5 percent, the rate of return on a contract that has the same terms as the host contract (and involves a debtor with a credit quality similar to that of B at debt inception) would be 11 percent (3M LIBOR of 5 percent plus 6 percent). The second condition is therefore also satisfied because when the 3M LIBOR 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 (3M LIBOR of 5 percent plus 6 percent) on the contract with the same terms as the host contract.

Companies A and B would each be required to account for the embedded derivative separately unless either has elected the option in ASC 815-15-25-4 or ASC 825-10-25-1 to measure the entire hybrid financial instrument at fair value, with changes in fair value recognized in earnings.

While the conditions in ASC 815-15-25-26(a) and (b) above focus on the
investor’s rate of return and recovery of its investment, if either of those
conditions is satisfied, neither party to the hybrid instrument would consider the
embedded derivative feature to be clearly and closely related to the host contract.
Furthermore, ASC 815-15-25-26 indicates that when an entity assesses whether it
meets one of the conditions, it should not consider whether it is probable that the
condition will be satisfied; the condition should be considered satisfied if there
is any possibility whatsoever that it will be met. Therefore, in the example above,
the probability that the 3M LIBOR will increase to 5 percent is not relevant to the
analysis of whether the condition is met. However, an entity should consider such
probability when valuing the embedded derivative.

See Section A.7 for further discussion of the application of the “double-double” test in ASC 815-15-25-26(b).