For financial risk management, 2022 was an eventful year. Alongside the oft-focused issue of commodity or energy price risk, this year also saw the end of the phase of negative reference interest rates. Acting in response to drastic increases in consumer market prices, the ECB changed its monetary policy in the middle of the year to effect a historic turnaround in interest rates. Following a 7-year period of negative reference rates, the ECB raised key interest rates by 75 basis points in two steps in the fall, among other things. Having raised rates by a further 50 basis points in December 2022, the ECB last adjusted key rates by another 50 basis points on 2 February 2023 and at the same time signaled its readiness for further interest rate hikes in the future. 

As a result of these developments, companies are once again focusing on the hedging of interest rate risks and hedge accounting in accordance with IFRS 9. And even companies that are not directly affected by interest rate rises at present should look into the development and the various hedging options. For instance, if a company intends to issue new debt in the future, as things stand today it is exposed to the risk that the interest rate level will continue to rise up to the actual issue, making the financing more expensive. Pre-hedging allows companies to specifically hedge against this risk. This article takes a closer look at the accounting implementation of such a pre-hedge by means of hedge accounting and at the factors that need to be taken into account for its successful implementation.

A pre-hedge lets companies secure current reference interest rates for future debt issues. In case a (re-)financing is planned or required as part of the financing strategy, the company can enter into corresponding hedging transactions, e.g. forward starting interest rate swaps, already at the time of planning. With a forward starting interest rate swap, the exchange of interest payment flows is not to begin until a future date, but it is to take place at conditions fixed on the trade date. By means of such an instrument, the current interest rate level for a future debt issue can be fixed. Provided that the hedging relationship meets all the applicability requirements, it can be recognized in the balance sheet under cash flow hedge accounting. Once a hedged, fixed-interest liability is issued, the hedging transaction is closed out and the hedging results are continuously reclassified to net interest income.1

By way of example, Company A might plan to issue a fixed-rate bond in January with a volume of EUR 100 million and a term of five years in July of the same year. To lock in the current interest rate level, A decides to enter into a forward starting interest rate swap with Bank B. The key parameters of the swap concluded in January (e.g. start of maturity in July over 5 years, nominal EUR 100 million) are the same as those of the planned bond. The swap is to be closed out on the day of the issue. Company A designates the swap as a hedging instrument (IFRS as part of a cash flow hedge, the underlying transaction is the planned issue (IFRS Thereafter, changes in the swap's fair value are recognized in the cash flow hedge reserve until it is closed out and subsequently amortized to net interest income over the bond's term to maturity. 

For hedge accounting to be stable, the company preparing the financial statements must take into account a number of factors. In principle, the continuous reclassification of the hedging result accrued in the cash flow hedge reserve must be made using the effective interest method. In addition to the effective interest rate for the financial liability (IFRS, a further notional effective interest rate is calculated taking into account the market value of the swap on settlement. This effective interest rate is then used to reclassify the hedging results to net interest result, causing the interest expense for the respective period to approximate the interest rate level prevailing at the designation date. To what extent a straight-line reclassification is more practicable is to be agreed with the auditor, taking into account materiality. It is also necessary to assess whether, in individual cases, the effective interest rate would correspond to the nominal interest rate anyway.

Additionally, the repayment structure of the liability must be taken into account when reclassifying the hedging results. In the case of an annuity loan, for example, with correspondingly continuous repayments, the liability's continuously decreasing nominal value must be taken into account when reclassifying the swap's fair value. In this case, a nominal-weighted reversal of the cash flow hedge reserve prevents a systematic misstatement of the interest expense.

It is also necessary to take into account situations in which there is a change in the expected cash flows during the term of the hedged liability. Such a change (IFRS, 9.B5.4.6) typically occurs when the original contract of the liability includes a renewal option, allows for early settlement based on a termination option, or provides for interest payments to change in accordance with a margin grid. In these specific situations, a dedicated case-by-case analysis is necessary to be reasonably certain that a correct reclassification will continue to be made.

Should there be an adjustment to the contractual arrangement instead of a change in the expected cash flows and therefore a modification of the financial liability (IFRS, it has to be distinguished whether the contractual adjustment is a substantial or non-substantial modification. If it is not a non-substantial modification, the individual case must be assessed for its impact on the reversal of the cash flow hedge reserve, analogously to the change in expected cash flows. If, however, it is a substantial modification of the contractual cash flows, the original liability must be derecognized and a new liability recognized in accordance with IFRS As far as hedge accounting is concerned, this means that the original hedged item no longer exists and hedge accounting must therefore be reversed. The residual amount in the cash flow hedge reserve must be transferred in full to the income statement at the time of modification.

In conclusion, it should be mentioned that the handling of credit default risk plays a non-negligible role in the application of a pre-hedge. According to IFRS, the credit risk must not dominate the hedging relationship. In other words, the credit risk may not consistently neutralize the offsetting changes in value of the hedged item and the hedging instrument. In addition, the fair value of the hedging instrument must be adjusted for the effect of credit default risk (CVA/DVA, see IFRS 13.42). As the latter is not part of the hedging relationship or a component of the hedged item, taking the CVA/DVA into account will therefore lead to computational ineffectiveness. Especially in the case of long-dated and large-volume swaps, selecting the appropriate calculation method has a significant impact on the amount of ineffectiveness calculated. 

In this context, the application of the so-called add-on method is not recommended. This method involves adding a maturity- and instrument-specific premium to the current market value as an estimated value to account for the uncertainty regarding future performance. In the case of interest rate swaps, this simplified method often leads to an overestimation of the risk position and as a result also of the correction amount for the CVA/DVA. Instead, it is recommended to use the variable exposure method or even a simulation-based method. Under the variable exposure method, the exposure pattern is tracked using the cash flows computed for fair value measurement. By contrast, simulation-based methods determine various exposure profiles based on data from a distribution. Both methods lead to more accurate CVA/DVA results than the add-on method and as a result to lower ineffectiveness in hedge accounting.

In the light of the current interest rate environment, the implementation of a pre-hedge and its recognition in the balance sheet by means of hedge accounting provides a practical opportunity to secure the current market inter-est rate level for planned debt issues. Our Finance and Treasury Management team will be happy to meet with you for a hands-on exchange and further discussion.

Source: KPMG Corporate Treasury News, Edition 129, January/February 2023
Ralph Schilling, CFA, Partner, Head of Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG 
Jan-Philipp Wallis, Senior Manager, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG


1 By contrast, when a floating rate liability is issued, the swap continues.