Contractually linked instrumentsContractually linked instruments

Contractually linked instruments

B4.20 In some types of transactions, an entity may prioritise payments to the holders of financial assets using multiple contractually linked instruments that create concentrations of credit risk (tranches). Each tranche has a subordination ranking that specifies the order in which any cash flows generated by the issuer are allocated to the tranche. In such situations, the holders of a tranche have the right to payments of principal and interest on the principal amount outstanding only if the issuer generates sufficient cash flows to satisfy higher-ranking tranches.

B4.21 In such transactions, a tranche has cash flow characteristics that are payments of principal and interest on the principal amount outstanding only if:

(a) the contractual terms of the tranche being assessed for classification (without looking through to the underlying pool of financial instruments) give rise to cash flows that are solely payments of principal and interest on the principal amount outstanding (e.g. the interest rate on the tranche is not linked to a commodity index);

(b) the underlying pool of financial instruments has the cash flow characteristics set out in paragraphs B4.23 and B4.24; and

(c) the exposure to credit risk in the underlying pool of financial instruments inherent in the tranche is equal to or lower than the exposure to credit risk of the underlying pool of financial instruments (for example, this condition would be met if the underlying pool of instruments were to lose 50 per cent as a result of credit losses and under all circumstances the tranche would lose 50 per cent or less).

B4.22 An entity must look through until it can identify the underlying pool of instruments that are creating (rather than passing through) the cash flows. This is the underlying pool of financial instruments.

B4.23 The underlying pool must contain one or more instruments that have contractual cash flows that are solely payments of principal and interest on the principal amount outstanding.

B4.24 The underlying pool of instruments may also include instruments that:

(a) reduce the cash flow variability of the instruments in paragraph B4.23 and, when combined with the instruments in paragraph B4.23, result in cash flows that are solely payments of principal and interest on the principal amount outstanding (e.g. an interest rate cap or floor or a contract that reduces the credit risk on some or all of the instruments in paragraph B4.23); or

(b) align the cash flows of the tranches with the cash flows of the pool of underlying instruments in paragraph B4.23 to address differences in and only in:

(i) whether the interest rate is fixed or floating;

(ii) the currency in which the cash flows are denominated, including inflation in that currency; or