Matching adjustment portfolio: a downgrade and a make-whole call in the same quarter

1. The downgraded £120m bank bond

• MA eligibility is an asset-level test applied on an ongoing basis; investment grade credit quality is one of the conditions. A move from BBB+ to BB+ takes the asset below the threshold, so prima facie it is no longer eligible. The exact wording of the permission, any cure period and the notification obligation must be confirmed with the PRA before the year-end close.
• Mark-to-market: spread widening of roughly 150bp on a modified duration of 6.5 implies a price fall of about 10 points, i.e. a £12m hit to own funds.
• A trap worth explaining to the board: if the asset stays eligible, the MA benefit on it may actually rise, because the benefit is the excess of the asset spread over the long-term fundamental spread, and 280bp of market spread exceeds the BB-band fundamental spread (say 130bp). That is not a reason to keep it - the fundamental spread is a long-term average and the firm is now bearing real default risk.
• If the asset becomes ineligible it must leave the portfolio and the liabilities it backs lose the adjustment. The adjustment attributable to it was roughly (90bp − 40bp) × 6.5 × £120m ≈ £3.9m, but the cliff is larger if removal disturbs the portfolio-level MA ratio test.

Options: (i) sell now - crystallise about £12m, coverage falls from 138% to roughly 136.5%, but removes the cliff and the default risk; (ii) hold pending the PRA's view - cheapest on paper, highest regulatory risk; (iii) transfer to a ring-fenced non-MA portfolio backing non-MA business - avoids a forced sale but attracts spread risk capital and requires non-MA business to back; (iv) partial sale.

2. The £80m callable bond A make-whole call is one of the limited exceptions to the no-call-features rule, because the redemption amount compensates the holder for lost interest. Eligibility is therefore preserved, but the cash flows now end at the call date. The bond must be revalued on the make-whole formula, and the proceeds reinvested in nine months at unknown yields. Action: verify the make-whole calculation, revalue, and budget for reinvestment risk.

Why the proposal fails

1. Eligibility is an asset-level test, not a portfolio-level one. If the BB+ bond is ineligible, it is ineligible in any MA portfolio. A new portfolio cannot cure a non-qualifying asset.
2. An MA is a permission, not an election. It is granted for a defined, ring-fenced pool of business that must be self-supporting with matching assets and liabilities. Creating a second portfolio means splitting the existing liabilities, which breaks the matching of the current portfolio, changes the portfolio-level MA ratio test and requires a full application - months, not weeks. During the application the proceeds sit outside any MA portfolio.
3. Cost and complexity. A second portfolio means duplicated asset-liability matching, MA ratio monitoring, model governance and audit, for a pool of about £200m.

What the board should decide

• Sell the bank bond, executed over a short window to limit market impact, unless there is a documented, evidence-based case that a rating recovery within twelve months is the base case.
• Retain the callable to the call date and table the reinvestment plan now, including the spread needed on replacement assets to preserve the MA benefit.
• Do not apply for a new MA portfolio unless a specific new business block needs one.
• Notify the PRA of the downgrade and the decision; reflect the sensitivity of the coverage ratio to further downgrades of the largest ten holdings in the ORSA and the year-end returns.
• Add a rating-migration trigger to the investment policy: any holding within one notch of the investment grade boundary needs a pre-agreed action plan and an owner.
• Consider splitting any sale across two or three counterparties to reduce market impact, and check whether the loss is better taken in the current or the next reporting period given the risk appetite floor.