Accounting Standard Updates
Does your ETF belong on Schedule D-1 – Long-term Bonds? What about Preferred Stocks?
Article reading time: 2 minutes 30 seconds
In May 2021, the NAIC Securities Valuation Office (SVO) put the Valuation of Securities Task Force (VOSTF) on notice of a proposed amendment to clarify the structural requirements for determining funds as “fixed income.” The exposed modification will impact whether an Exchange Traded Fund (ETF) qualifies under the revised SVO structural requirements to be included within the scope of SSAP No. 26R – Bonds, and reported on Schedule D-1 – Long-Term Bonds. The amendment further applies to preferred stock ETFs falling within the scope of SSAP No. 32R – Preferred Stocks. At issue is the use of derivatives within ETF funds and the need to establish measurable boundaries in derivative volume and application.
This is a VOSTF exposure item at this stage, with a comment deadline of July 1, 2021.
VOSTF Exposes Proposed Amendments to the P&P Manual of the NAIC Investment Analysis Office – ETF Bond and Preferred Stock Clarification
The VOSTF previously requested the SVO to assess the existing guidance with the objective of providing additional clarity and acceptability to investors regarding the use of derivatives in funds, and with the further desire to allow some funds more flexibility in their usage of derivatives. Consequently, at the March 2021 Spring National Meeting, the SVO provided several proposed amendments to the Practices & Procedures Manual of the NAIC Investment Analysis Office (P&P Manual). The proposal was exposed to Interested Parties for 45 days, received comments, and culminated in this final proposed amendment to the P&P Manual fund guidelines.
So, what’s the rub?
The amendment provides additional guidance through the creation of a more straightforward test to govern whether or not a fund’s use of derivatives will be considered fixed income-like.
ETFs containing certain derivative vehicles can qualify as a fixed-income security and be included on the SVO-Identified Bond ETF listing. To qualify as a fixed income-like security, the proposed guidance stipulates the following:
- Derivatives with the risk of future payment obligations would be limited to 10% of the fund based on the gross notional amount, which is considered the more conservative approach. The noted derivatives exclude currency or interest rate hedges pertaining directly to fixed income or equity assets held in the fund;
- All derivatives, including those with only potential gain, would be limited to 20% of the fund. The cap allows the portfolio to continue to meet the “predominantly holds” test in the P&P fund guidance. Derivatives with only potential gain would be measured based on the market value, a less conservative approach. Again, the amendment excludes currency or interest rate hedges pertaining directly to fixed income or equity assets held in the fund;
- Currency and interest rate hedges that specifically hedge assets held in the portfolio are not subject to limitation for the reason that the hedges are established to make sure the fund meets the specified objective with fixed interest rates or payment in a certain currency (e.g., U.S. currency hedges).;
Final analysis of the exposed guidance:
To meet the eligibility requirements of the SVO-Identified Bond Listing, an ETF must hold at least 80% of its assets in bonds. This is not new guidance within the P&P Manual. VOSTF provides the example that if a fund were to include 15% in stocks, the fund would only be allowed to hold 5% in derivatives, with the exclusion of currency or interest rate hedges that directly hedge fixed income or equity assets held in the fund;
The amendments clarify the provisions for overall holdings of derivatives (20%), and derivatives with risk of future payment requirements can be no more than 10% of the portfolio (or half the 20%).
This dialogue is provided in conjunction with our previous article (here) describing the SAPWG proposed definition of what comprises a bond for inclusion in Schedule D-1 – Long-Term Bonds in the statutory financial statement.