Funding with bonds, sukuk and mortgage-backed issues

Mortgage refinance companies typically fund long-dated, prepayable mortgages with bonds or sukuk of shorter or fixed maturities, sometimes secured on or backed by the mortgage pool. The issuer must classify each instrument (a sukuk with a contractual obligation to pay periodic distributions and redeem the principal is a financial liability, whatever its name), measure it at amortised cost with issue costs spread through the EIR, and assess covenants such as minimum capital ratios, loan-to-value limits or pool coverage tests. A covenant breach at the reporting date can make the debt repayable on demand and change its classification, and the mismatch between the duration of assets and liabilities is the company's central liquidity and interest rate risk, which IFRS 7 requires to be explained.

Does each bond or sukuk contain a contractual obligation to deliver cash, so that it is a financial liability under IAS 32, and are there features (perpetual terms, discretionary distributions, conversion) that need separate analysis? Are issue costs (arranger fees, legal, rating, listing) deducted from the initial carrying amount and amortised through the EIR? For mortgage-backed or covered issuances, does the company retain the mortgages on balance sheet (because it keeps the risks, or because the issuing vehicle is consolidated), with the notes as its liability? Which covenants exist, when are they tested, and was any breached at or before the reporting date without a waiver obtained by then? If the company presents assets and liabilities in order of liquidity, are amounts due within and after twelve months disclosed? Do the maturity analysis and interest rate sensitivity show the mismatch between asset and liability repricing and maturity?

1. Classify each instrument issued under IAS 32 on its substance: an obligation to pay distributions and redeem principal makes a bond or sukuk a financial liability; analyse separately any equity features.
2. Recognise the liability when the company becomes party to the contract (issue date) at fair value less directly attributable transaction costs, normally the proceeds received less issue costs.
3. Measure subsequently at amortised cost using the EIR, which spreads issue costs and any discount or premium over the expected life of the instrument.
4. For mortgage-backed or covered issuances, first determine whether the issuing vehicle is consolidated and whether the mortgages qualify for derecognition (see BANK-028); if they do not, keep the mortgages and recognise the notes as a liability, disclosing the assets pledged.
5. Where the company presents a classified statement of financial position, classify a liability as non-current only if at the reporting date it has a right to defer settlement for at least twelve months; covenants affect that right only if compliance is required on or before the reporting date.
6. A breach at the reporting date that makes the debt repayable on demand makes it current, even if a waiver is obtained after the reporting date; a waiver obtained by the reporting date that gives at least twelve months' grace preserves non-current classification.
7. For covenants tested within twelve months after the reporting date, keep the classification but disclose the risk.
8. Derecognise or modify debt under the IFRS 9 liability requirements when it is repaid early, exchanged or substantially modified.

Initial carrying amount = proceeds - directly attributable issue costs. EIR = the rate that discounts the contractual payments (coupons or periodic distributions and principal) to that amount. Interest expense each period = opening carrying amount x EIR; the excess over cash coupons accretes the liability back to par by maturity. Where the instrument has a call option or is expected to be repaid early (for example pass-through notes repaid as mortgages prepay), estimated cash flows reflect the expected repayment pattern and changes in estimates produce catch-up adjustments. Embedded derivatives in the debt are assessed for separation under IFRS 9.

Disclose: (1) the terms of each significant bond or sukuk issue, including maturity, rate and security; (2) carrying amounts of assets pledged as collateral for issued notes; (3) any defaults or breaches of loan agreements during the period, the carrying amount of liabilities in breach at the reporting date and whether the breach was remedied or terms renegotiated before the financial statements were authorised; (4) for liabilities classified as non-current but subject to covenants tested within twelve months, the nature of the covenants, the carrying amounts and any indications of difficulty complying; (5) a maturity analysis of financial liabilities showing remaining contractual maturities, and a description of how liquidity risk arising from the mismatch with longer-dated mortgages is managed; (6) interest rate sensitivity reflecting repricing and duration mismatch; (7) amounts expected to be settled within and after twelve months where a liquidity-order presentation is used.

• Expensing issue costs immediately or presenting them as a separate prepaid asset
• treating sukuk as equity because of their name or structure without analysing the contractual obligation
• derecognising mortgages placed in a funding vehicle that the company consolidates or whose risks it keeps
• keeping debt as non-current when a covenant was breached at year end and the waiver came after the reporting date
• reclassifying debt as current because a covenant will be tested next year (the requirement is disclosure, not reclassification)
• presenting only contractual maturities of assets when prepayments make expected maturities very different, without explaining how liquidity risk is managed