IFRS 9 amendments – a tailwind for sustainable debt

In May 2024, the International Accounting Standards Board (IASB) released amending guidance¹  to its accounting standards for financial instruments, IFRS 9. A number of the amendments centre on the Solely Payments Of Principal and Interest (SPPI) test, which plays a significant role in the classification and measurement of bonds and other debt instruments.

Addressing Industry Concerns and Market Evolution

As the IASB was performing its post-implementation review of IFRS 9, many within the industry became concerned about IFRS 9’s requirements for assessing contractual cash flow characteristics on fixed income assets, particularly as they pertained to debt instruments with features linked to sustainability or environmental, social, and governance (ESG) issues. IFRS 9 was initially finalized in 2014 and went live for European IFRS filers in 2018. However, because of the IASB’s recent project to revamp the accounting for insurance contracts (IFRS 17), most insurance companies were given a reprieve from adopting IFRS 9 until 2023, which lined up with IFRS 17’s effective date. This was done to allow for a more harmonious implementation and to lessen the effects of any asset-liability mismatches. Unsurprisingly, during this lengthy delay in implementation, a natural evolution of markets followed, and over the last decade, there has been significant growth in green, social and sustainable debt issuance.

SPPI Test and Classification Rules

The IFRS 9 classification rules stipulate that, for a bond to be held at either amortised cost (AC) or fair value through OCI (FVOCI), it must pass the SPPI test. This is important because bonds held at AC or FVOCI are able to shield market volatility from an insurer’s earnings.

When analysing a bond for SPPI purposes, the rules emphasize that its cash flows must be consistent with a basic lending agreement. Specific to the interest component, the assessment focuses on what an investor is being compensated for, rather than how much compensation the investor receives (though the amount of compensation may indicate that the investor is being compensated for something other than basic lending risks and costs). Contractual cash flows are considered to be inconsistent with a basic lending arrangement if they include compensation tied to variable or market factors that are not typically considered to be basic lending risks or costs. Typical basic lending risks includes the consideration of credit risk or liquidity risk. Interest rate risk is another common consideration – which can be addressed through the issuance of floating or variable rate instruments with coupons tied to commonly used benchmark reference rates such as SONIA, ESTR, SOFR, etc.

Contingent Events and ESG Metrics

Furthermore, if there are terms that could change the timing or amount of contractual cash flows, the investor needs to assess the nature of any contingent event or trigger, and its effect on the instrument’s cash flows. For a change in contractual cash flows to be consistent with a basic lending arrangement, the contingent event must not result in cash flows that are significantly different from the expected cash flows absent of any contingent event. The analysis of cash flows can be performed qualitatively, but depending on the complexity of the contingent feature, may need to be performed quantitatively.

The sustainable debt market has seen rapid growth in recent years, with some instruments having its coupons tied to a specific ESG metric (e.g. carbon emissions) and an issuer may have its interest rate increased or decreased depending on its ability to meet an emissions target (the contingent event). For that instrument to pass the SPPI test, the instrument must have SPPI cash flows before and after the contingent event. Additionally, because contingent features linked to ESG targets like carbon emissions are not typical basic lending risks, the effects of the emissions target cannot result in cash flows that are significantly different from those that would exist if the contingent event did not occur.

If the instrument was, for example, designed to where its interest rate can be adjusted based on a market-determined variable, such as a carbon price index, (as opposed to a contingent event tied to the issuer), this type of metric would result in the instrument failing the SPPI test because the instrument’s cash flows are linked to a variable that is not a basic lending risk or cost.

Clarity for Sustainable Bond Investors

With the IASB amending its guidance²  on matters affecting of sustainability / ESG-linked instruments, the hope is that this will provide clarity for bond investors, particularly for companies sensitive to the accounting treatment of their bond portfolios. This should also lessen concerns for investors and issuers of sustainable debt, as EU regulators push to meet its climate policy goal for a more sustainable economy.

Author: Wheatley Garner, Head of Accounting Policy and Strategy, Global Insurance Solutions

¹ IFRS 9 Financial Instruments: new paragraphs B4.1.8A and B4.1.10A; amended paragraphs B4.1.10, B4.1.13, B4.1.14

² The amended paragraphs in IFRS 9 become effective for annual reporting periods beginning on or after January 1st 2026. Early adoption is also permitted.

Late August often provides a useful vantage point for reflection on the year so far, which enables us to fine tune our expectations for what is to come in the coming months ahead. As we write, the US and European yield curves have rebased to levels previously seen in January of this year, apparently erasing the expectation changes discounted in the previous seven months. This seems somewhat unfair, as the global macro picture appears clearer than it was in January.

Opportunities for Insurance Investors

For insurance investors, the present market appears generous with its offering and thus we expect to be busy for the remainder of the year.  We note an uptick in available yields across a variety of asset classes which presents opportunities for strategic asset allocation. For example, current UK gilt yields continue to support the bulk annuity theme. While spreads remain low relative to historic ranges, we see this reflecting a convergence in risk between higher quality private sector balance sheets and a more challenged public sector balance sheet. As a result, we see carry at the heart of the conversation for insurance investors.

If there is a common theme to the opportunity presented by the market currently, it is that credit’s income pickup appears well placed relative to sovereign – especially at the shorter end. In investment grade credit markets, issuers’ fundamental quality remains robust, commonly helped by a lengthening in average life.  In sovereign markets, the short end of both the US and Euro government curves offer appealing yields, while longer duration maturities appear better anchored. In Europe, we think longer dated sovereign bonds may offer a better opportunity as long dated corporate spreads are quite tight.

Medium-Term Market Opportunities and Macro Themes

At present, the market is well positioned to provide opportunity in the medium term. We see a series of macro themes playing out to insurer advantage in coming months. In our view, the key drivers of fixed income return are well positioned to provide attractive return drivers.

First, 2024 has seen a notable cooling in global inflation, creating policy space for a response. Whether we consider US, UK or European inflation as our chosen indicator,  we see evidence of economic cooling. Of those three, the US has shown the most vigour, which has challenged the US Federal Reserve’s (Fed) policymakers; back in January, the market expected 5 Fed cuts in 2024, while today’s expectations look for the Fed to begin cutting in September. The Bank of England saw sufficient room to begin its cutting cycle in August, with the Governor casting the deciding vote against the Bank’s chief economist. In Europe, the ECB continued to hold, with market expectations of a cut growing.

Second, cooling inflation is a function of moderating growth. Our second global investment quarterly concluded that sub trend growth remained our base case expectation – and so it has proven. While the US economy remains robust, there is evidence that the effects of Fed policy are being felt. In Asia, China’s economic growth has been challenged by a more complex export picture. Japan’s decision in the quarter to exit Quantitative Easing (QE) – the last of the Central Banks to do so – was enough to provoke investor concerns around tightening financial conditions.

Third, central banks preparing to cut rates suggest that we have entered the late stage of the global economic cycle. US equity returns seem to support this view: the rally in US equities has seen market leadership thin to a short list of names. Remove these, and US equity returns look more pedestrian.

Opportunities in a Changing Landscape

Further, the most recent earnings season has shown more positive earnings surprises from defensives than cyclicals, suggesting that Corporate America is also seeing the changes in the boardroom. European and UK shares offer more attractive multiples than their US peers, balanced against less impressive earnings growth. In our view, a slowing in global growth can provide support for fixed income returns, to the advantage of longer-term asset holders.

Lastly, concerns in one area can create opportunities in others. A slowing of the US economy has led to speculation that the dollar may soften. This may lead to rallies in assets elsewhere: for example in emerging markets, where we note that local central banks moved ahead of the Fed on inflation and are now cutting earlier to protect local growth. A softening dollar may make support the case for local currency assets in less complex economies.  EM assets tend to offer attractive returns when the US economy is reaccelerating and when Chinese growth rates are positive. When both themes are in place, the space can surprise positively. 

Author: Giles Bedford, Senior Investment Specialist, EMEA Insurance