Matching Adjustment Eligibility of a Callable Solar Bond
A UK life insurer writes bulk purchase annuities and manages a £3.2bn matching adjustment (MA) portfolio with an average book yield of 4.1% and a Solvency II coverage ratio of 145%. The investment committee is considering a £250m allocation, 7.8% of the MA portfolio, to 12-year fixed-rate sterling-hedged solar project bonds issued by a single special purpose vehicle. The bonds yield 5.6%, are rated BBB, and have a three-year construction phase during which interest is capitalised; after year five they are callable at par. Currency exposure will be hedged with a cross-currency swap. The assets would be funded by selling gilts and supranational holdings. The committee is attracted by the 150bp spread pick-up, which its model shows adds roughly 4 percentage points to the coverage ratio, but the risk function has flagged the structure. The ORSA identifies a 1-in-200 stress of 120bp spread widening combined with a two-notch downgrade.
1. Assess whether the bonds meet the matching adjustment eligibility requirements.
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MA eligibility rests on a small number of strict conditions: fixed cashflows; no terms that can change them; not a derivative; held to maturity; sufficient credit quality; and cashflows in the same currency as the liabilities, or perfectly swapped.
- Fixed cashflows. The construction phase with capitalised interest is the first problem. Until the plant is operating, cashflows depend on completion and on the SPV's ability to service debt. Contractually fixed capitalised interest may be acceptable in form, but the regulator will look at substance and at whether the cashflows can be relied on through stress.
- Callable at par after year five. This is a refinancing option held by the issuer. It changes the cashflows and is the clearest eligibility obstacle. It may be acceptable only if the call price is compensatory, that is, a make-whole that leaves the insurer economically indifferent. That must be tested and documented, not assumed.
- Currency. A cross-currency swap can be used, but the swap is itself a derivative and its cashflows must be fixed; the hedge must be perfect, and counterparty risk is added to the MA portfolio.
- Credit and diversification. BBB is at the weaker end of what is acceptable, and a single SPV at 7.8% of the MA portfolio is a concentration the 'sufficiently diversified' test may not tolerate.
- Held to maturity. A 12-year asset with a construction phase and an embedded call is harder to hold through a spread-widening episode.
Conclusion: the bond is not clearly eligible as structured. The construction phase and the call are the binding issues.
2. Recommend whether to proceed, with conditions, and quantify the main risk to the coverage ratio.
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Recommendation: do not buy the bond into the MA portfolio in its current form. Conditions under which it could proceed:
- Hold it in the shareholder fund during construction and transfer only on completion, once cashflows are contractual and the plant is operating.
- Negotiate removal of the call, or a make-whole at a spread that makes exercise uneconomic, and obtain written confirmation from the MA auditor before purchase.
- Cap the position at 3-4% of the MA portfolio and require a second, uncorrelated issuer before building to 7.8%.
- Document the swap as a perfect hedge and include counterparty risk in the SCR.
Quantification. With effective duration around 9, a 120bp widening on £250m is a loss of roughly £27m, about 0.8% of a £3.4bn SCR. That is enough to erase most of the modelled 4 percentage point coverage gain. A two-notch downgrade to BB would also force the asset out of the MA portfolio, crystallising the loss and removing the MA benefit at the same time. The 150bp pick-up is compensation for exactly these risks; the committee can be paid for them in the shareholder fund, where a mark-to-market loss does not threaten the MA calculation, but not in the MA portfolio.