Credit linked note under IFRS 9

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pplu
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Credit linked note under IFRS 9

Post by pplu »

Hello,

Considering a single name vanilla CLN, issued via bank programme (rather than SPV programme) so investors bear credit risk on both reference entity and issuer, pays fixe rate with 1y maturity, underlying being US government bills. Could it be booked at amortised cost, provided the business model is held to maturity?

many thanks

Pplu
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JakobLavrod
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Re: Credit linked note under IFRS 9

Post by JakobLavrod »

Hi!

Disclosure: I normally do not work with these types of products, so for anyone more familiar, feel free to correct me.

From the perspective of the investor that has the default risk: No, this has to be booked at FVPL.
From the perspective of the senior tranche that is protected against the defaults: Yes, you can book at it amortized cost as long as the underlying instruments pass the SPPI test and the credit risk of the tranche is lower than the credit risk of the original pool, however, it is probably a good idea to check out IFRS 9 B4.1.20 - B4.1.26 to make sure you satisfy all the conditions.
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pplu
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Re: Credit linked note under IFRS 9

Post by pplu »

Thanks for your reply.

For the CLN in question, there is no tranche and the investor bears default risk towards both reference entity (US) and the issuing bank.

As the investor intends to hold the note to maturity, and the note is paying fixed rate, I would book it as amortized cost rather than separating CDS from the host contract, not booking it in FVTPL. Would it make sense to you?

Hao
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JakobLavrod
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Re: Credit linked note under IFRS 9

Post by JakobLavrod »

Hi!

Thank you for the response, I think I was a little bit unclear, so let me give some additional context.

There are two things to assess if you can hold the instrument at amortized cost:
1) Business model should be hold to collect contractual cash flows - This seems correct from your information
2) Cash flows should pass the SPPI test - they should be solely payments of principal and interest. In particular, there can be no leverage elements. I think this is the one where at least I do not have sufficient information from your description. If for example, there is a setup in which the bank has a priority claim to cash flows up to a certain level, then that is an element of leverage.

If you could provide additional details of the relation between the note holder, bank, and reference entity, it would help in understanding if SPPI is valid.
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pplu
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Re: Credit linked note under IFRS 9

Post by pplu »

Thanks for your replay.

to provide more detail as requested: the issuer has no priority in cash flow. it simply pays a fixed rate to the investor. If the reference entity (US) defaults, the note is immediately settled in cash and all the proceeds will be repaid to the investor. if the issuer defaults itself, the regular default settlement process will be applied.

Pplu
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JakobLavrod
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Re: Credit linked note under IFRS 9

Post by JakobLavrod »

Hi!

Thank you for providing additional information. So if the instrument pays a fixed interest rate over time, and I assume it pays out the face value at maturity, how is the instrument different from a regular fixed interest bond? If not, I agree that you can hold it at amortized cost. Just trying to understand better if there are some additional constraints?
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Re: Credit linked note under IFRS 9

Post by pplu »

Thank you for the reply.

If the reference entity default, the note is immediately repaid (cash settlement) for the recovery value of the US treasury bond.
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Re: Credit linked note under IFRS 9

Post by JakobLavrod »

Hi!

Thank you for the additional information. Hence the way I interpret the instrument is that
A) If the references entity pays as per the contract, a fixed rate is obtained
B) If the reference entity defaults, a recovery payment is instantly made.

In such case, based on the information given, there seems to be nothing that indicates that the SPPI test is violated, so it seems ok to account at amortized cost.
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pplu
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Re: Credit linked note under IFRS 9

Post by pplu »

Thank you for the analysis.

My only concern was that given the structure of the note, one may consider there is a leverage in terms of interest payment (it pays both the issuer spread and the CDS spread). Would it invalidate the SPPI?
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Re: Credit linked note under IFRS 9

Post by JakobLavrod »

So the CDS element here, if I understand it correctly, lowers the LGD by providing a payout in case of default. The fact that this risk reduction means that one must pay a slight premium should not influence the SPPI assessment.
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Re: Credit linked note under IFRS 9

Post by pplu »

Thanks a lot. It was really helpful. Much appreciated.
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