2022 was an eventful year for financial risk management. In addition to the issue of commodity and energy price risk, which often takes centre stage, this year also saw the end of the phase of negative reference interest rates. In response to drastically increased consumer market prices, the ECB changed its monetary policy in the middle of the year and completed a historic turnaround in interest rates. After seven years of negative reference interest rates, the ECB raised its key interest rates by 75 basis points in two steps in the autumn. After a further increase of 50 basis points in December 2022, the ECB last adjusted its key interest rates by a further 50 basis points on 2 February 2023 and at the same time declared its willingness to raise interest rates further in the future.
These developments are bringing the hedging of interest rate risks and hedge accounting in accordance with IFRS 9 back into the focus of companies. Even companies that are not currently directly affected by interest rate rises should consider the development and the various hedging options. If, for example, a company is planning a new debt issue in the future, it is currently exposed to the risk that interest rates will continue to rise until the actual issue, making the financing more expensive. Companies can specifically hedge against this risk with a so-called pre-hedge. This article takes a closer look at the accounting implementation of such a pre-hedge using hedge accounting as well as any points that need to be considered for successful implementation.
Companies can use a pre-hedge to secure current reference interest rates for future debt issues. If (re-)financing is planned or required as part of the financing strategy, the company can conclude corresponding hedging transactions, such as forward starting interest rate swaps, at the time of planning. A forward starting interest rate swap provides for the exchange of interest payment flows to begin at a future date, but at conditions fixed on the date of conclusion. Such an instrument can be used to fix the current interest rate level for a future debt issue. If the hedging relationship fulfils all application requirements, it can be recognised in the balance sheet as part of cash flow hedge accounting. When a hedged, fixed-interest liability is taken up, the hedge is then closed out and the hedging results are continuously reclassified to net interest income.1
For example, Company A could plan in January to issue a fixed-interest bond with a volume of €100 million and a term of 5 years in July of the same year. In order to secure the current interest rate level, A decides to conclude a forward starting interest rate swap with Bank B. The swap concluded in January matches the value-critical parameters (e.g. start of term in July over 5 years, nominal €100 million) with those of the planned bond. The swap is to be settled on the day of issue. A designates the swap as a hedging instrument (IFRS 9.6.2.1) as part of a cash flow hedge; the hedged item is the planned issue (IFRS 9.6.3.1). Subsequently, changes in the market value of the swap are recognised in the cash flow hedge reserve until it is closed out and subsequently amortised to net interest income over the term of the bond.
In order to enable stable hedge accounting, the reporting company must take a number of factors into account. For example, the continuous reclassification of the hedging result accumulated in the cash flow hedge reserve must be carried out using the effective interest method. In addition to determining the effective interest rate for the financial liability (IFRS 9.5.3.1), a further notional effective interest rate is calculated taking into account the market value of the swap when it is closed out. This effective interest rate is then used to reclassify the hedging results to net interest income and results in the interest expense for the respective period approximating the interest rate level prevailing at the time of designation. The extent to which a straight-line reclassification is more practicable must be agreed with the auditor, taking materiality into account. It must also be assessed whether the effective interest rate would correspond to the nominal interest rate in the individual case anyway.
Furthermore, the amortisation structure of the liability must be taken into account when reclassifying the hedging results. For example, if it is an annuity loan with corresponding continuous amortisation payments, the continuously decreasing nominal value of the liability must be taken into account when reclassifying the market value of the swap. In this case, a nominal-weighted reversal of the cash flow hedge reserve prevents a systematic misstatement of the interest expense.
In addition, situations in which there is a change in the expected cash flows during the term of the hedged liability must be taken into account. Such a change (IFRS 9.5.4.3, 9.B5.4.6) occurs, for example, if the original contract for the liability contains an extension option, allows early repayment on the basis of a cancellation option or provides for interest payments to change in accordance with a margin grid. In these special situations, a dedicated case-by-case analysis is necessary to ensure that the reclassification continues to be correct.
If, instead of a change in the expected cash flows, there is an adjustment to the contract and therefore a modification of the financial liability (IFRS 9.3.3.6), a distinction must be made as to whether the contractual adjustment is a substantive or non-substantive modification. If it is not a non-substantial modification, the individual case must be assessed in terms of its impact on the reversal of the cash flow hedge reserve, analogous to the change in expected cash flows. However, if it is a substantial modification of the contractual cash flows, the original liability must be derecognised and a new liability recognised in accordance with IFRS 9.3.3.2. For hedge accounting, this means that the original hedged item no longer exists and hedge accounting must therefore be cancelled. The amount remaining in the cash flow hedge reserve must be transferred in full to the income statement at the time of the modification.
Finally, it should be mentioned that the handling of credit default risk plays a not insignificant role in the application of a pre-hedge. According to IFRS 9.6.4.1(c)(ii), the credit risk must not dominate the hedging relationship. This means that the credit risk must not continuously neutralise the opposing changes in value of the hedged item and the hedging instrument. Furthermore, the fair value of the hedging instrument must be adjusted for the effect of the credit default risk (CVA/DVA, see IFRS 13.42). As this is not part of the hedging relationship or part of the hedged item, recognising the CVA/DVA consequently leads to arithmetical ineffectiveness. The choice of the appropriate calculation method has a significant influence on the amount of the calculated ineffectiveness, particularly in the case of long-term and large-volume swaps.
The use of the so-called add-on method is not recommended. Here, the current market value is supplemented by a maturity- and instrument-specific add-on, which is intended as an estimate to take account of the uncertainty regarding future value development. In the case of interest rate swaps, this simplified procedure regularly leads to an overestimation of the risk position and consequently the correction amount for the CVA/DVA. Instead, the variable exposure method or even a simulation-based method is recommended. In the variable exposure method, the exposure progression is traced using the cash flows calculated for the fair value calculation. Simulation-based methods, on the other hand, determine various exposure curves based on information from a distribution. Compared to the add-on method, both methods lead to more accurate CVA/DVA results and therefore to reduced ineffectiveness in hedge accounting.
Against the background of the current interest rate environment, the implementation of a pre-hedge and its mapping in the balance sheet using hedge accounting offers a sensible way of securing the current market interest rate level for planned debt issues. The Finance and Treasury Management Team will be happy to provide you with a practical exchange and further discussion.
Source: KPMG Corporate Treasury News, Issue 129, January/February 2023
Authors:
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 If a variable-rate liability is issued, however, the swap is continued.
