Treatment of Interest on Indexed-Linked Debt Instruments

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Two papers:

Instruments indexed to foreign currency:

Separate discussion; option to treat it as “denominated” in that currency.

Instruments indexed to something else (e.g., CPI, share prices, oil price):

Issues are how the indexation amounts are:

• classified as interest or revaluation; and

• allocated over the life of the instrument.

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Index-linked securities in the SNA7.104. Index linked securities are financial instruments for which the amounts of the coupon payments (interest) and/or the principal outstanding are linked to a general price index, a specific price index or an exchange rate index. 

When the coupon payments are index linked, the full amounts of such payments are treated as interest receivable or payable, in the same way as the interest receivable and payable on any other security paying a contractually agreed variable income.

When the value of the principal is index linked, the difference between the eventual redemption price and the issue price is treated as interest accruing over the life of the asset in the same way as for a security whose redemption price is fixed in advance. In practice, the change in the value of the principal outstanding between the beginning and end of a particular accounting period due to the movement in the relevant index may be treated as interest accruing in that period, in addition to any interest due for payment in that period. ...

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Issues

Redemption value is not known– Implication: value of interest before redemption

is unclear.

It is argued that some indexation (such as to stock prices, oil prices, gold prices) combines motives for both interest income and holding gains.

Interest is the return for putting financial resources at disposal of another entity.Holding gains/losses effect of index value fluctuations.

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Issues

Are negative values of interest payable/receivable acceptable or meaningful, when general interest rates are positive?

Or are such fluctuations an indication that the value is driven by revaluation factors rather than being a return for supplying financial resources?

Business accounting does not have the interest/holding gain distinction.

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1993 SNA Approach

Keeping the 1993 SNA unchanged for the concept of interest and not allowing revisions of interest accruals (when the coupons are index-linked, the full amounts paid as coupons, after indexation, are accrued as interest; and when the value of the principal is index-linked the difference between the actual redemption value and the issue price is treated as interest accruing over the life of the instrument (paragraph 7.104)). For determining interest accruing in an accounting period, the movement in the relevant index during the period is used to determine interest accruing in that period, without revising them later.

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1993 SNA Approach

Year Opening balance

Interest Revaluation Closing balance

1 1000 70 -12 1058

2 1058 60 -17 1101

3 1101 160 58 1319

4 1319 190 10 1519

5 1519 -77 -39 1403

Total 403 0

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1993 SNA Approach

Comments:

Interest is volatile due to movements in index.

Revaluations are due to changes in market expectations about future path of the index. It could arise also from market interest rate changes or credit ratings (in this example, these were assumed unchanged).

Revaluations cancel out over life of instrument.

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1993 SNA with revision/s

Keeping the 1993 SNA unchanged for the concept of interest, and accepting revisions of interest accruals that will be determined in each accounting period either

(a) by using the movement in the relevant index in each accounting period and revising interest when actual redemption value is known, or

(b) by using the most recent observation of the relevant index and revising interest continuously.

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1993 SNA with one final revision

Year Opening balance

Interest Revaluation Closing balance

Initial Final Initial Final

1 1000 70 70 -12 -12 1058

2 1058 60 75 -17 -32 1101

3 1101 160 80 58 138 1319

4 1319 190 86 10 114 1519

5 1519 -77 92 -39 -208 1403

Total 403 403 0 0

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1993 SNA with regular revisions

Year Opening balance

Interest (estimates made in the year)

1 2 3 4 5

1 1000 70 63 89 103 70

2 1058 67 96 114 75

3 1101 105 125 80

4 1319 138 86

5 1519 92

Total 403

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1993 SNA with revision/s

Comments:The total interest accrued over the life of the instrument is the same with that in the 1993 SNA approach. The allocation over the life is different. Revaluations cancel out over the life of the instrument.The issue is whether it is desirable to revise interest accruals:(a) when actual cash flows are know at the redemption.(b) on a regular basis using the latest information (on the

index).

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Modified debtor approach

Clarifying or changing the 1993 SNA for defining interest on index-linked instruments by fixing the rate of interest at the time of issue, and treating any deviation of the index from the expected path as holding gains/losses.

AEG discussion in December 2004 was helpful; this option had previously been ruled out of consideration.

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Modified debtor approach

Year Opening balance

Interest Revaluation Closing balance

1 1000 80 -22 1058

2 1058 86 -43 1101

3 1101 94 124 1319

4 1319 100 100 1519

5 1519 109 -225 1403

Total 469 -66

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Modified debtor approach

Comments

Interest accruals are calculated using the expected yield-to-maturity (YTM) at issue.

Interest for the life of instrument may not be equal to the difference between issue price and redemption value.

Revaluations may not cancel out over the life of the instrument (equal to the difference between expected and actual redemption value).

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Embedded derivative approach

Clarifying or changing the 1993 SNA for defining interest by regarding indexed-linked instruments as effectively including derivative contracts. This is similar to previous approach. However, interest is imputed based on a similar instrument that is not indexed and the value of the embedded derivative reflects the deviation (of the imputed interest) from actual movements in the relevant index.

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Embedded derivative approachStandard bond component

Year Opening balance

Interest Revaluation Closing balance

1 1000 80 0 1080

2 1058 86 0 1166

3 1101 94 0 1260

4 1319 100 0 1360

5 1519 109 0 1469

Total 469

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Embedded derivative approachDerivative component

Year Opening balance

Interest Revaluation Closing balance

1 0 0 -22 -22

2 -22 0 -43 -65

3 -65 0 124 59

4 59 0 100 159

5 159 0 -225 -66

Total -66

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Embedded derivative approach

Comments

Interest accruals are imputed based on similar instruments that are not indexed. Effectively, for the debtor approach, this means using the expected YTM at issue.

Derivative reflects the deviation of imputed interest from actual movements of the relevant index.

The standard bond component may also have revaluation if market interest rate changes. Then, it becomes difficult how to disentangle revaluations due to change in index or due to market interest rates.

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Discussion point

Which alternative, among the four presented in the Executive Summary, do the members prefer?

(a) 1993 SNA approach as it is?

(b) 1993 SNA with revisions:

• when actual redemption value is known?

• using the most recent observation?

(c) Modified debtor approach?

(d) Embedded derivative approach?

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BOPCOM discussion:

Evenly divided between (a) and (c).

Conclusion to keep the status quo – i.e., option (a) - in the absence of a consensus for change.

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