Corporates have rightfully been very careful when entering into derivative transactions. From evaluating risk management policy, weighing the economic benefits and navigating accounting, legal and regulatory requirements – a lot needs to happen before executing a hedge.
In an effort to make things easier on the accounting front, many are careful to match the terms of interest rate swaps to those of the debt or loan that is the source of the interest rate risk being hedged. This allows the company to apply simplified methods for hedge accounting. Under legacy US GAAP these methods help alleviate two key burdens of hedge accounting; (1) assessing whether the hedge meets effectiveness requirements and (2) having to accounting for ineffectiveness.
Under IFRS 9, there has to be an economic relationship between the hedged item and the hedging instrument, and hedge ineffectiveness has to be measured and accounted for.
So that raises the question, what happens when a company needs to change its existing hedge position?
As discussed in a prior Accounting Corner write up, hedge accounting rules have changed in a way that gives hedgers more flexibility to apply hedge accounting. The basic requirements for hedge accounting are still necessary, but under US GAAP hedgers may be able to use certain solutions that would have previously resulted in accounting noise.
One way to manage existing hedges is to do what is called a “blend & extend” trade. This is a trade where the existing mark to market of a hedging instrument is embedded into a new hedging instrument with an extended maturity date. This trade allows companies to term out their existing debt profile without having to terminate and settle their existing hedging instrument.
The key accounting hurdle is asserting that the new hedge is highly effective. Because of the embedded “off-marketness” of the blend & extend trade (i.e. it does not start with a fair value of zero), it has inherent ineffectiveness and therefore must be quantitatively analysed. Remember, hedges just need to be highly effective to qualify for hedge accounting (under US GAAP), which in practice is a range of 80 per cent to 125 per cent effective. Under IFRS 9, the corresponding requirement is not necessarily quantitatively expressed. If deemed highly effective, the blend & extend trade qualifies for hedge accounting and with there no longer being a requirement to measure and recognize ineffectiveness under US GAAP, the swap would just naturally accrue into earnings (i.e. aligned with the net settlements).
Changes in hedge accounting under IFRS also may help companies looking to hedge with a blend & extend trade. Under IFRS 9, qualifying for hedge accounting no longer looks to a “highly effective” threshold. Instead, an economic relationship between the hedging instrument and the hedged item needs to be exist. This may be simpler to establish versus the highly effective requirement under US GAAP. A key accounting downside under IFRS is that there is still a requirement to measure and recognize ineffectiveness. IFRS filers may want to analyse that potential noise before using this type of trade.
Below is an example analysis that assumes blending an existing 5 year swap that has rolled down 3 years to $18.4mm off-market (on $100mm notional) into a new 5 year hedge. An initial analysis shows that such a trade could be highly effective for hedge accounting purposes (US GAAP), the same analysis can also help support the economic relationship requirement (IFRS):
With points on the USD yield curve currently inverted and the potential for future rate cuts, many companies have been showing interest in terming out their debt. It’s important to consider the various alternatives available to accomplish this, both synthetic and natural. Given new rules, even companies sensitive to accounting noise should make sure to include blend & extend trades on their list of alternatives.
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