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4.4 Debt hosts
Publication date: 31 Jul 2022
us Derivatives & hedging guide
The most common type of hosts are debt hosts. See FG 5.4 for information regarding how to determine whether an equity contract is a debt or equity host.
Generally, embedded derivatives in debt host contracts are not clearly and closely related if they introduce risks that are not typical for debt instruments or if the return that investors may receive is significantly leveraged (i.e., favorably or unfavorably impacted to a significant degree by the embedded derivative). When applying the clearly and closely related criterion in ASC 815-15-25-1(a) to a debt host, the focus should be on determining whether the economic characteristics and risks of the embedded derivative have features unrelated to interest rates (e.g., equity-like or commodity-like features) or credit risk of the issuer. When the characteristics of the derivative are related to interest rates, the focus should be on determining whether the features involve leverage or change in the opposite direction as interest rates (e.g., an inverse floater).
4.4.1 Common embedded features
Generally, an embedded derivative is clearly and closely related to a debt host if it is one of the following:
- A non-leveraged interest rate or index
- A non-leveraged index of inflation in the economic environment for the currency in which the bond is denominated
- The creditworthiness of the debtor
- An issuer-exercisable call or a holder-exercisable put that does not contain an embedded interest rate derivative under the guidance in ASC 815-15-25-26 and meets the requirements for not separating put and call options in ASC 815-15-25-41 through ASC 815-15-25-42
ASC 815-15-25-23 through ASC 815-15-25-51 provides guidance on how to apply the clearly and closely related criterion to different hybrid debt instruments with various embedded features.
Question DH 4-9
If a debt instrument contains an embedded derivative that results in the interest payments being indexed to the price of silver (or some other metal or commodity index) and they are settled in cash or in a financial instrument or commodity that is readily convertible to cash, must the derivative be separated from the host contract?
If a debt instrument contains an embedded derivative that results in the interest payments being indexed to the price of silver (or some other metal or commodity index) and they are settled in cash or in a financial instrument or commodity that is readily convertible to cash, must the derivative be separated from the host contract?
PwC response
Yes. In this situation, the issuer would be viewed as having (1) issued debt at a certain interest rate, and (2) entered into a swap contract to convert the index that determines the rate of interest from an interest rate index to a commodity index. The swap contract would not be considered clearly and closely related to the host contract because its economic characteristics are linked to a commodity index (rather than an interest rate index). Therefore, assuming the hybrid instrument is not being carried at fair value with changes recognized in current earnings and a separate instrument with the same terms as the embedded feature would be a derivative instrument under ASC 815, the embedded derivative should be separated from the host contract and accounted for separately as a derivative.
For further discussion on evaluating debt host contracts with embedded interest rate derivatives, including evaluation of whether the embedded derivative is clearly and closely related to the host contract, refer to FG 1.6.1.2. The guidance included in FG 1.6.1.2 is applicable to both investors and issuers of debt host contracts; the evaluation of any embedded interest rate derivatives would be based on the same guidance for both parties. However, an issuer and an investor may reach different conclusions based on their respective facts and circumstances. For example, an issuer may have issued an instrument at par, but an investor may have purchased it with a premium or discount so they may have different yields. This is discussed in ASC 815-15-25-27, which notes that the acquirer of a hybrid instrument in a secondary market could potentially reach a different conclusion than the issuer of the instrument.
4.4.2 Embedded put or call options
Put features allow the debt holder to demand repayment, and call features allow the issuer to repurchase the debt. It should be noted that in the context of debt instruments, puttable debt (i.e., that the holder may require to be repaid early) is often referred to in practice as callable, although callable debt theoretically is prepayable only at the issuer’s option. Generally, a put or call option is considered clearly and closely related to its debt host unless it is leveraged (i.e., it creates more interest rate and/or credit risk than is inherent in the host instrument). For example, debt issued at par value that is puttable at two times the par value upon the occurrence of a specified event may have an embedded component that is not clearly and closely related to its debt host instrument.
For further discussion on embedded put and call options within debt instruments, including examples on determining whether a put or call option is considered clearly and closely related to the host debt instrument, refer to FG 1.6.1.1. The analysis of whether or put or call option is clearly and closely related to the debt host contract would be based on the same guidance for both the issuer of the debt host and an investor in the debt host. However, an issuer and an investor may reach different conclusions based on their respective facts and circumstances. For example, an issuer may have issued an instrument at par, but an investor may have purchased it with a significant premium or discount. This is discussed in ASC 815-15-25-27, which notes that the acquirer of a hybrid instrument in a secondary market could potentially reach a different conclusion than the issuer of the instrument.
4.4.3 Issuer’s accounting for convertible debt
Convertible debt is a hybrid instrument composed of at least (1) a debt host instrument and (2) one or more conversion features (i.e., a written call option requiring delivery of company stock upon exercise of the conversion option by the holder). Many convertible debt instruments contain a conversion option with several settlement features that are interrelated. If, after performing the analysis of one settlement feature, it is determined that it should be separately accounted for as a derivative, then the entire conversion option should be separated and accounted for as a single derivative. The debt may also contain other embedded derivatives (e.g., puts and calls, contingent interest, make-whole provisions, other interest features). See DH 4.8.3 for information on multiple derivative features embedded in a single hybrid instrument.
For further discussion on the accounting for convertible debt, including analysis of the embedded conversion option, refer to FG 6.4 (post adoption of ASU 2020-06) and FG 6.4A (pre adoption of ASU 2020-06). The guidance used in the analysis of whether a host contract is a debt or equity host and whether the conversion option will meet the definition of a derivative is the same for both the investor and the issuer of the host contract. However, the analysis of whether an embedded conversion option will meet one of the scope exceptions in ASC 815 is different for issuers than for investors.
Issuers of convertible debt may qualify for the issuer own equity derivative scope exception in ASC 815-10-15-74(a). Refer to FG 5.6.2 and FG 5.6.3 (post adoption of ASU 2020-06) and FG 5.6.2A and FG 5.6.3A (pre adoption of ASU 2020-06) for discussion on whether an equity linked instrument meets the issuer own equity derivative scope exception. This scope exception does not apply to an investor in an instrument convertible into the equity of the issuer. As such, an investor in a convertible instrument will have to bifurcate the conversion option if the instrument is deemed to be a debt host and the embedded conversion option meets the definition of a derivative unless the investor is accounting for the instrument at fair value with changes in fair value reported in earnings.
See FG 6.5.1 (post adoption of ASU 2020-06) and FG 6.5.1A (pre adoption of ASU 2020-06) for information on the derecognition of convertible debt with a separated conversion option by the issuer of that instrument.
4.4.4 Conversion option no longer requires separate accounting by an issuer
ASC 815-15-35-4 provides guidance that addresses the issuing entity’s accounting for a convertible bond with a previously separated conversion option that no longer meets the criteria for separate accounting. Refer to FG 6.5.2 (post adoption of ASU 2020-06) and FG 6.5.2A (per adoption of ASU 2020-06) for further discussion.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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