The ECL Requirements – FAQ | IFRS

The ECL requirements

The Expected Credit Losses (ECL) requirement in IFRS 9 makes the initial selection of bonds for fixed income investments by financial institutions much more important, as selecting bonds with good long-term credit health is key to reducing the risk of future P&L fluctuations caused by changes in ECL. This is especially important for insurers that would like to adopt a buy-and maintain bond investment strategy.

In an ideal world, the best action is to sell the bond prior to the start of its credit quality decline. Such early action will avoid P&L volatility due to the subsequent increase in ECL.

However, in practice, a bond may only come into focus after its credit quality has started to deteriorate, by which time the credit spread is likely to have already moved up and the price may have fallen significantly. At that point, trading out of the bond position will involve realizing a loss. Therefore, investors must accept a trade-off between suffering a current loss and the avoidance of a potentially larger P&L fluctuation in the future due to any ECL increase.

The potential impact of the introduction of an ECL calculation on investment strategy can be illustrated by looking at bonds issued by Petrobras, the Brazilian oil group. Take, for example, “PETBRA 5.75% 20 January 2020”—a USD 2.5 billion 10-year senior unsecured bond issued by Petrobras with a 5.75% coupon on 30 October 2009.

On 10 September 2015, Standard & Poor’s announced a double-notch downgrade for Petrobras, taking the company’s foreign currency long-term rating from BBB- to BB. This decision followed a downgrade to Brazil’s sovereign rating (Exhibit A). Following subsequent downgrades to Petrobras by Moody’s and Fitch, the company’s credit rating was deemed to be sub-investment grade by all three major rating agencies. As a result, the company’s bonds no longer qualified for certain investment grade bond indices.

Exhibit A: Rating actions on PETBRA 5.75% 20 January 2020 by S&P and MOODY’S

Rating actionsBrazil spreads were 25-50 basis points wider after the country’s credit downgrade. However, Petrobras suffered more significant price falls and a greater widening in its yield spread following its downgrade (Exhibit B).

Exhibit B: Option-adjusted spread for PETBRA 5.75% 20 January 2020

The downgrade by Moody’s on 29 January 2015 represented a critical decision point for investors. At this point, the bond was trading at about $95 per $100 notional, which was below its issuance price. It was still rated as investment grade, hence investors may still choose to rely on the “low credit risk”16 definition under IFRS 9. In deciding whether to sell the bond, an investor would need to consider the tradeoff between the desire to avoid potential future P&L volatility caused by an increase in the ECL requirement, and the recognition of a realized loss on the immediate sale of the bond.

The Expected Credit Losses requirements

The Expected Credit Losses requirements

The Expected Credit Losses requirements The Expected Credit Losses requirements The Expected Credit Losses requirements The Expected Credit Losses requirements

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