Holding downgraded corporate bonds in an annuity portfolio
You manage the assets backing a £3.2bn portfolio of level-payment immediate annuities with a liability duration of 11 years. The portfolio is 55% corporate bonds (average rating A-, average spread 110bp), 30% gilts and 15% infrastructure debt. A rating agency has downgraded 8% of the corporate bond holdings from A to BBB. Under the internal model's credit-risk allowance and the matching adjustment eligibility rules you apply, BBB assets receive a smaller matching adjustment and a higher fundamental spread, and assets below BBB are ineligible. BBB spreads have widened 60bp following a sector shock. The annuities are illiquid and cannot be repriced; new business is written at a 20bp margin over the matching-adjusted yield. The board asks whether to sell the downgraded bonds, hold them, or restructure the portfolio.
1. Analyse the three options, quantifying the main effects on solvency and on asset-liability matching.
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Exposure. Downgraded assets are 8% x 55% x £3.2bn = £141m, with duration around 11 years. A 60bp spread widening implies a mark-to-market fall of roughly 11 x 0.6% = 6.6%, about £9m.
Option 1: hold. The £9m is unrealised and the bonds still pay coupons, but the matching adjustment falls. If the matching adjustment on £141m drops by, say, 40bp, the present value of liabilities backed by these assets rises by approximately 11 x 0.4% x £141m = £6.2m, so the combined solvency cost of holding is around £15m. Holding also leaves the portfolio one notch from ineligibility: a further downgrade forces a sale at the worst time and could breach the matching test.
Option 2: sell and reinvest. Selling crystallises the £9m loss and incurs perhaps 30bp of transaction cost (£0.4m), but restores eligibility and buys assets at wider spreads, so the reinvestment yield is higher. Net solvency cost now, but no cliff-edge risk and the new assets earn 60bp more, which recovers the loss over about 6-7 years.
Option 3: restructure. Sell the weakest names, retain the strongest BBBs, and use infrastructure debt to fill the duration gap. This keeps some spread but requires the infrastructure pipeline to be available and raises concentration in an illiquid, model-valued asset class.
Recommendation. Sell the names with the weakest fundamentals and hold the rest only if the resulting matching adjustment haircut is explicitly modelled and the portfolio stays within a 5% BBB limit. Present the solvency position under each option and under a further one-notch downgrade.
2. Explain how this decision interacts with new business pricing and with the risk of selecting against the fund.
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Pricing constraint. New business is priced at a 20bp margin over the matching-adjusted yield. If the matching adjustment on the affected assets falls by 40bp, the fund's achievable yield on that £141m falls by 40bp, which is twice the entire new-business margin. Writing more business at that price while holding ineligible or haircut assets means the new policyholders are being promised yields the assets cannot support, and the shortfall lands on the estate and existing policyholders.
Anti-selection. The annuity book cannot be repriced once written, so if the fund's yields deteriorate it must either raise new-business prices (losing volume to competitors with clean portfolios) or stop writing. The danger is asymmetric: continuing to write at 20bp while spreads are 60bp wider and eligibility is impaired transfers value from the fund to new customers.
Practical steps. First, recompute the matching-adjusted yield and the new-business internal rate of return using the post-downgrade asset portfolio, not the target portfolio. Second, set a pricing floor that reflects the actual portfolio yield plus a stress allowance for another notch of downgrade. Third, if the recalculated margin is negative, pause new business rather than dilute. Fourth, document the analysis for the board so the decision to hold or sell is explicitly linked to the price at which the fund is willing to write, and disclose the concentration limits and the monitoring triggers for further downgrades.