Supervisory Treatment of Individual Features of Corporate Bonds Under the PRIIPs Regulation

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Guidance Notice

Business sign: VBS 1-Wp 5430-2019/0071

19.09.2019

In July 2018, the Joint Committee of the European Supervisory Authorities analysed the treatment of corporate bonds under the PRIIPs Regulation and requested the European Commission to publicly clarify the scope of the Regulation or to confirm this analysis. The European Commission replied by way of a letter dated 14 May 2019.

Nevertheless, there is still continuing uncertainty about the applicability of Regulation ( EU ) No 1286/2014 of the European Parliament and of the Council of 26 November 2014 on key information documents for packaged retail and insurance-based investment products ( PRIIPs ) (hereinafter referred to as the “PRIIPs Regulation”) to corporate bonds, which is why the Securities Supervision has set out its position on this in the following Guidance Notice:

According to the legal definition set out in point 1 of Article 4 of the PRIIPs Regulation, a packaged retail investment product (hereinafter referred to as a “PRIP”) is “an investment [...] where, regardless of the legal form of the investment, the amount repayable to the retail investor is subject to fluctuations because of exposure to reference values or to the performance of one or more assets which are not directly purchased by the retail investor”.

The
PRIIP manufacturers and persons advising on, or selling, such products to retail investors, are initially responsible for determining which products must comply with the requirements of the PRIIPs Regulation. This assessment must take into account, in particular, the specific economic features and contractual terms and conditions of each product.

The following information, which is not exhaustive, outlines BaFin’s administrative practice regarding the supervisory treatment of corporate bonds in relation to the interpretation of the PRIIPs Regulation as at the date of this Guidance Notice. The individual features of a corporate bond must be considered on a case by case basis in order to assess whether the bond must be treated as a PRIP or not.

1. Feature: Perpetual

Perpetual corporate bonds are not treated as
PRIPs
. This is because in particular the amount repayable (which is defined as comprising both interest and principal repayments) is not subject to fluctuations because of exposure to a reference value, due to the fact that it is perpetual.

2. Feature: Subordinated

Subordinated corporate bonds are not treated as PRIPs . This is because in particular the amount repayable is not subject to fluctuations because of exposure to reference values, due to its subordination. Even cases of qualified subordination do not lead to the corporate bond being classified as a PRIP .

3. Feature: Fixed rate

Fixed-rate corporate bonds are not treated as a PRIPs . This is because in particular the amount repayable is not subject to fluctuations because of exposure to a reference value, due to the fixed interest rate. This also applies in cases in which a corporate bond does not pay any interest, i.e. where it has a zero coupon.

Additionally, a corporate bond is not subject to fluctuations because of exposure to reference values, and therefore does not represent a PRIP , if the terms and conditions of the bond provide for predefined changes in the coupon rate at fixed times prior to maturity, e.g. if the coupon rate increases annually on predefined dates (this is known as a “step-up bond”).

4. Feature: Changes in the amount repayable (interest and principal) depending on exposure to reference values

In principle, predefined conditional or unconditional changes in coupon rates that do not depend on exposure to reference values or to the performance of one or more assets do not lead to the corporate bond being classified as a PRIP . This includes in particular changes in coupon rates as a result of issuer rating downgrades, a change of control, or tax or regulatory events.

However, where the amount repayable (defined as comprising both interest and principal repayments) is subject to fluctuations because of exposure to reference values, the nature of the reference value in question must be examined in more detail. To start with, the term “reference value” as used in the PRIIPs Regulation must be interpreted broadly. For example, the value of (other) securities, indices, commodities or physical assets is a reference value within the meaning of the PRIIPs Regulation. Where the amount repayable is subject to fluctuations because of exposure to such a reference value, the corporate bond must be classified as a PRIP . The same also applies if the amount repayable is only subject to fluctuations because of exposure to a reference value in certain circumstances, for example in the case of the early redemption of the corporate bond (as is regularly the case e.g. with “redemption at make-whole”).

Where the amount repayable, e.g. the coupon, is directly linked to an interest rate index such as Euribor or Libor , this reference value exceptionally does not lead to the corporate bond being classified as a PRIP , even though in this case as well the amount repayable is subjection to fluctuations since it is linked to an index. This is by analogy with deposits, which specifically do not count as “structured deposits”, and hence do not fall within the scope of the PRIIPs Regulation pursuant to Article 2(2) (c) of the PRIIPs Regulation, if they are variable rate deposits whose yield is directly linked to an interest rate index such as Euribor or Libor (cf. section 2 (19) sentence 2 of the German Securities Trading Act (Wertpapierhandelsgesetz)). However, the situation is different where there is other structuring above and beyond the direct link to an interest rate index, as is the case for example with maximum or minimum coupon rates (with the exception of zero coupons).

Additionally, a distinction must be made in individual cases as to whether the reference value must be treated as issuer- or group-related, and hence qualifies as an internal reference value or whether it is independent of this and must be treated as belonging to a separate reference value category. As a matter of principle, internal reference values do not lead to the bonds in question being PRIPs . Issuer- and group-related performance indicators such as the amount of the retained earnings, EBITDA or the dividend rate must always be treated as internal reference values.

5. Feature: Puttable/callable

Where a corporate bond is puttable/callable by the issuer and/or creditor, this in itself does not lead to the bond being a PRIP .
Although the amount repayable of the bond is subject to regular fluctuations due to early termination, these fluctuations do not occur because of exposure to a reference value.

6. Feature: Conversion right or right to subscribe for other securities

Where a corporate bond features a conversion right or right to subscribe for other securities (e.g. shares), as is the case for example with (mandatory) convertible bonds and bonds with warrants, it must be treated as a PRIP . In this case the amount repayable is subject to fluctuations because of exposure to a reference value that is not directly purchased in those cases in which the conversion right or option is exercised.

Footnotes:

Letter by the Joint Committee of the European Supervisory Authorities dated 19 July 2018 (JC 2018 21), accessible at https://esas-joint-committee.europa.eu/Publications/Letters/JC%202018%2021%20(PRIIPs%20Joint%20Letter%20to%20COM%20on%20Scope)%20GBE.pdf Letter by the European Commission dated 14 May 2019, accessible at https://www.eiopa.europa.eu/content/european-commissions-reply-esas-call-clarify-scope-priips-regulation The guideline set out in note 5 of the communication from the European Commission, Guidelines on the application of the PRIIPs , Regulation, OJ EU No C 218 dated 7 July 2017, page 11 (2017/C 218/02). It should be noted that the concept of "reference value" as used in the PRIIPs Regulation is not identical to the concept in point 39 of Article 2(1) of the Markets in Financial Instruments Regulation (MIFIR) or point 29 of Art. 3(1) of the Market Abuse Directive ( MAD ). This can be clearly seen from the English version of the texts: the PRIIPs Regulation uses the term "reference value", while MIFIR/MAD use "benchmark". Please see point 4) for information on the early repayment of the corporate bond in the case of termination.

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