SAPWG Exposes Proposed Bond Definition: What Belongs in Schedule D-1?

Background:

In 2013, SAPWG began its Investment Classification Project to commence a comprehensive review of the investment SSAPs in order to clarify definitions, scope, and the accounting methodology, along with related reporting. The project specifically targeted an intent to assess investments that waver outside the existing investment-type definitions and then study characteristics to ensure proper valuation and reporting. Following the initial start of the project, the Working Group has adopted substantive revisions to SSAP No. 26R—Bonds, SSAP No. 30R—Common Stock, and SSAP No. 32R—Preferred Stock.

Subsequently, in 2019, analysis was started on SSAP No. 43R – Loan-backed and Structured Securities with the initial focus of concentrating on the underlying equity investments supporting these vehicles. As discussions ensued, the process deepened into a comprehensive review of this SSAP under the Investment Classification Project. It evolved to the point of issuance of an issue paper.  Following further hearings on the issue paper, the project advanced into a suggestion from the Iowa insurance department to reconsider the process of comparing SSAP 26R against SSAP 43R and taking a more holistic, principles-based methodology. The concluded goal was to actually define what qualifies a bond’s eligibility for inclusion on Schedule D-1: Long-Term Bonds. With that change in focus, a small group was formed to study and propose a more formal definition of what comprises a security determined to qualify for Schedule D-1 reporting. This JLKR update encompasses the culmination of the 43R group consensus and what currently stands in the exposed definition.

Highlights of the Proposed Bond Definition:

Since this item is in its exposure period, we will keep it to a brief synopsis of the flavor of the definition.

• A bond must represent a substantive credit relationship, not just appearance in legal form. This includes the supposition that an investment that relies on equity return cash flows is not a bond.  This can only be overcome by a formally documented breakdown showing the recharacterization of those primary equity risks into bond risk by way of collateral structuring and diversification.
• Bonds are either obligations of an issuer, or they are asset-backed securities (ABS). An issuer obligation is defined as one being primarily buoyed by the general creditworthiness of an operating entity (or several entities). Examples provided include bonds issued by REITs, bonds issued by closed-end funds, project finance bonds, other operating entities properly registered under the 1940 Act, equipment trust certificates, and properly supported credit tenant loans. The exposed definition includes a more exhaustive list of qualifying securities.
• Asset-backed securities are issued by organizations that have the principal focus of raising debt that is collateralized by cash flows to service the debt. A special purpose vehicle (SPV) is the general method employed to issue the ABS debt; however, it is not a specifically required component. An ABS is supported (backed) by either financial assets or non-financial cash-generating assets.
• For an ABS to meet the bond qualification, it must place the investment holder outside the economic position of actually owning the supporting collateral, which is accomplished by providing guarantees or other recourse. Further, non-financial cash-generating assets supporting an ABS are required to generate “meaningful” cash flows with the ability to repay the debt (other than through sale or refinancing of the assets). Notwithstanding, non-financial assets must be of a nature that their structure produces sufficient fixed-income-like cash flows.
• The exposure makes it clear that quality documentation of the bond determination analysis must be developed and maintained for distribution to regulators and auditors upon request. The definition of the quality documentation component is included in the exposure under the glossary terms “sufficiency” and “meaningful.”

Summed up, the objective of the exposed definition is to incorporate the principles that apply to all investments to be included in Schedule D-1, thereby avoiding future detours for special considerations of varying investment formats and structures (e.g., credit tenant loans).

Items remain open to be finalized, such as transition guidance (grandfathering provisions are not expected to be entertained), how to improve transparency in reporting Schedule D-1, development of an updated issue paper to support the final approved bond definition, and how to handle investments that may not fall under (or fit) within SSAP No. 48 – Joint Ventures, Partnerships and Limited Liability Companies, and yet do not meet the bond definition.

Final Tidbits:

If you thought the bond definition was a mouthful, to add to your plate, the Valuation of Securities Task Force (VOSTF) just recently released an exposure document defining further requirements in determining whether funds are considered “fixed income”.  The intent is to address derivatives being held within Exchange Traded Funds (ETFs), and may further determine whether an ETF meets the requirements to be held within the scope of SSAP No. 26R – Bonds, which are reported as SVO-Identified Bond ETFs on Schedule D-1.

Stay tuned for Part 3 of this riveting series regarding the recent VOSTF development.