Interest rate swap on debt

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Leo
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Interest rate swap on debt

Post by Leo »

Hi,

Our company has contracted with a bank an interest rate swap for our loan. The purpose of the loan was to purchase a building.

The loan was initially borrowed at a variable rate, we are swapping it against a fixe interest rate.

IFRS9.B6.5.1 says that IRS used to hedge exposure to fair value changes of a fixed-rate debt even if the set instrument is accounted for at amortized cost should be eligible as a fair value hedge, so that any variation should go to P&L.

My question would be :

In our case, we are swapping variable interest rate against a fixed interest rate, would that still be a Fair value hedge?

Could this be a cash flow hedge?

Thank you
hubertd
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Re: Interest rate swap on debt

Post by hubertd »

Fair falue of an instrument can only change if an instrument is at fixed rate. Put differently, there’s no fv risk of a variable rate instrument so there’s nothing to hedge. What you’re talking about is a classic cash flow hedge.
Leo
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Re: Interest rate swap on debt

Post by Leo »

Thank you !!!!
Leo
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Re: Interest rate swap on debt

Post by Leo »

what's the fair value hedge for cause the variation of the fair value is recognized in P&L?
Leo
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Re: Interest rate swap on debt

Post by Leo »

Just to see if someone might be interested to answer my question.

Thank you.

"what's the fair value hedge for cause the variation of the fair value is recognized in P&L anyways"?
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Marek Muc
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Re: Interest rate swap on debt

Post by Marek Muc »

I, for example, don't understand your question
Leo
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Re: Interest rate swap on debt

Post by Leo »

Sorry if I wasn't clear.

If a company applies hedge accounting on the derivatives, the fair value variation should be booked in the P&L.

If the company don't apply hedge accounting on the derivatives, the fair value variation is also booked in the P&L.

My question was, why apply hedge accounting on instruments that belongs to fair value hedge.

Thanks
pub_acco
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Re: Interest rate swap on debt

Post by pub_acco »

Under the fair value hedge accounting, the gain/loss arising from the derivative adjusts the book value of hedged item (e.g. financial liability measured at amortized cost). In this way the effective portion of the gain/loss is eliminated from P&L.
Leo
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Re: Interest rate swap on debt

Post by Leo »

Thank you for your answer!

However, if the derivatives for hedge purposes aren't eligible to hedge accounting, the gain/loss is also booked in the P&L, canceling the gain/loss of the hedged items in the P&L.

To apply Hedge accounting, companies have to prepare extra documentation which is often onerous as work.

So, why bother to apply the hedge accounting, cause if the company doesn't, gain&loss of the hedging derivatives will be booked into P&L anyways along with the gain&loss of the hedged items.
pub_acco
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Re: Interest rate swap on debt

Post by pub_acco »

You will not remeasure an amortized-cost loan, so no gain/loss would arise from the hedged item without the fair value hedge accounting. The fair value of a fixed-rate loan changes as the market interest rate changes, so it is a reasonable strategy for the management to contract a derivative to hedge the fair value changes, but as long as the loan is accounted for as an amortized cost instrument, only the gain/loss arising from the derivative affects PL. The fair value hedge accounting is used to fix this accounting mismatch. You may also elect to use the fair value option, but hedge accounting usually provides greater discretion.
Leo
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Re: Interest rate swap on debt

Post by Leo »

Thank you very much! it's very clear.

Can I contract derivatives to hedge the loan without applying the hedge accounting? So far, the only advantage of applying fair value hedge accounting is that I can book the fair value of the derivatives along with the hedged item instead of financial instruments in the balance sheet. I don't see any difference in the P&L between applying hedge accounting or not.

I don't want to do the effectiveness tests neither to disclose it extensively in the financial report, it's too much work.
pub_acco
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Re: Interest rate swap on debt

Post by pub_acco »

You can contract a derivative without hedge accounting, but PL does change depending on whether you apply hedge accounting or not. Without hedge accounting, the gain/loss from the derivative hits PL in full. With hedge accounting, you can remove a portion of the derivative gain/loss that corresponds to the hedged item from PL.
Leo
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Re: Interest rate swap on debt

Post by Leo »

Hi,

thank you very much, I see it now.

Could you confirm my understanding :

Case :

I'd like to contract an FV derivative to hedge my loan at amortized cost. The FV of the derivatives is nil at inception (01.01.2021) and the FV of the derivatives is 10€ at the closing date (31.12.2021)

Without hedge accounting :
DR Financial instruments (derivatives) 10 Balance sheet
CR FV variation from FI 10 P&L

With hedge accounting
DR Financial instruments (derivatives) 10 Balance sheet
CR Loan 10 Balance sheet

Is that correct?

Thank you very much for your patience !!!
pub_acco
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Re: Interest rate swap on debt

Post by pub_acco »

Correct! (if the hedge is fully effective)
Leo
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Re: Interest rate swap on debt

Post by Leo »

So why are we always talking about FV hedge accounting with variation booked in P&L ???

For example :

Page 3 : https://www.cmegroup.com/education/file ... epaper.pdf
Leo
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Re: Interest rate swap on debt

Post by Leo »

From my understanding, if it was correct.

For example, a lot of companies have their portfolio of government bonds and corporate bonds in their asset (cash management). If these instruments pass the SPPI tests and qualified as hold to collect and sell, the variation should go to OCI.

But, if you hedge these bonds by derivatives, the variation of these bonds should be accounted in P&L along with the variation of the FV hedge derivatives.

Thus, you'll have 0 variations in your bonds portfolio (if it's 100% effective), and you'll have 0 in your P&L (not OCI)



However, in my case, I'm hedging a loan as a liability. And My loan is booked at amortized cost and I don't adjust it each year at fair value, and I don't think a lot of listed companies do it neither. If I apply what IFRS tells me, I think that I really should book the variation of the derivatives in P&L. Does it mean that I should start to adjust my loan (liabilities) at Fair value (with impact in P&L) instead of amortized costs in order to counterbalance the effect of the derivatives? (the problem of my accounting entry above is that the carrying value of my loan had changed, and I don't think that's correct because the goal of FV hedge is to have 0 variation on the carrying amount of my loan)

And if my understanding above was correct, What's the difference between applying hedge accounting or not, cause either way, the variation of the fair value of the derivative instruments are booked into P&L. Why do I have to bother?
DJP
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Re: Interest rate swap on debt

Post by DJP »

Hi Leo,

The objective of a fair value hedge is that the fair value changes on your hedged item (the fixed-rate borrowing) are compensated by the fair value changes on your hedging instruments (the IRS).

You are right when you say that what you are trying to achieve is a zero change in fair value, but this is achieved because the fair value of the derivative may go up and the fair value of the borrowing will do down (and vice-versa). So the fair values are netting each other out.

From an economic point of view this will happen (assuming obviously that the terms of the IRS match the terms of the loan). But from an accounting point of view you have a small "issue". Your borrowing is accounted for at amortised cost, and your derivative is accounted for at FVTPL. This means that even though you may be 100% hedged economically, your P&L is not reflecting this given the different accounting rules for borrowings and for derivatives. So the solution in this case is to apply hedge accounting. Hedge accounting is optional and what it does is to allow you to book fair value adjustments (for the part of the hedge that is effective) on top of the borrowing that is being carried at amortised cost. Those adjustments are booked against P&L, thus matching the fair value changes of the IRS.

Makes sense?
Leo
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Re: Interest rate swap on debt

Post by Leo »

Clear => blur => clear => blur => clear

That resumes my learning process of IFRS.

Thank you DJP, thank you Pub Acco, for your great patience.

Thank you Marek for your forum.
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Marek Muc
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Re: Interest rate swap on debt

Post by Marek Muc »

It's real treasure to have pub_acco and DJP onboard
Leo
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Re: Interest rate swap on debt

Post by Leo »

sorry for being ponderous and stubborn.

Just allow me to give an example :

My company contracted from a bank a borrowing of 500M€ at 01.01.2021 at a 5% interest rate fixed rate. Supposing that there are no costs at inception, EIR = Nominal interest rate. And my company will reimburse the loan at maturity in 10 years in full.

So, the fair value of my loan is 500M€ at inception (01.01.2021), and this is the amount that I'll book in my books. Thus, It's 500M€ that I'll have in my books as well at 31.12.2021.

Suppose that I've contracted an interest rate swap (receive fixed rate and pay variable interest rate) on 01.01.2021, with the same terms as the loan and supposing also that my swap is 100% effective.

In the case that the interest rate does drop from 5% to 1%, the FV of my borrowing should increase, let's say from 500M€ to 560M€. But in my books, I'll still have 500M€ unchanged because I book it at amortized cost. On the other hand, my derivatives will have a value of 60M€ for example.

So, from my understanding, if I apply the hedge accounting, I should book the following :

DR SWAP derivatives asset 60M€ (Balance sheet)
CR FV change from SWAP derivatives 60M€ (P&L)

DR FV change from loan at amortized cost 60M€ (P&L)
CR Loan at amortized cost 60M€ (Balance sheet)

So, no impact in P&L, and my loan at 31.12.2021 will be 560M€ which will be counterbalanced by the FV of the SWAP ASSET 60M€.

If I don't apply the hedge accounting, I should book the following :

DR SWAP derivative asset 60M€ (Balance sheet)
CR FV change from SWAP derivatives 60M€ (P&L)

So, I'll have an impact of 60M€ (profit) in my P&L

Am I right or am I completely wrong?
pub_acco
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Re: Interest rate swap on debt

Post by pub_acco »

Perfect! Converting a fixed-rate loan payable to a floater is the typical situation where FV hedges come into play.
Leo
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Re: Interest rate swap on debt

Post by Leo »

Thank you Pub acco !!!

However, that means that if I'm applying the hedge accounting, my loan will soar from 500M€ to 560M€. There might be risks that I'll break the covenants and the CEO doesn't like it when debt increase like that...
JRSB
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Re: Interest rate swap on debt

Post by JRSB »

In some cases big swings in P&L are the CEO's problem...

Useful thread! :ugeek:
Leo
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Re: Interest rate swap on debt

Post by Leo »

Hi guys,

Just came across an interesting article I wanna share with you on this topic :

https://www.cpajournal.com/2017/11/27/i ... lue-hedge/

Thanks !
pub_acco
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Re: Interest rate swap on debt

Post by pub_acco »

IFRS 9 doesn't have a direct shortcut provision, but I've seen in practice some entities skip the effectiveness test under perfect hedges, and I've also seen a real disclosure that omits effectiveness-related information, saying that hedges are all perfect. That's often enough for many corporates that engage a simple hedging activity, and I guess IFRS 9 anticipates that by not strictly requiring quantitative effectiveness tests.
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