Portion of a credit spread remunerating expected default and downgrade cost, published by the European supervisor and deducted from any discounting adjustment.
A corporate bond's spread remunerates three distinct things: expected default risk, downgrade risk that would force a sale at the wrong moment, and the security's illiquidity. Only the third component can be appropriated by an insurer holding to maturity, since the first two correspond to real losses it will suffer on average. The fundamental spread is the regulatory estimate of the first two, published by the European insurance authority by asset class, rating and duration, from long-term default statistics and transition matrices. It works as a floor: the matching adjustment equals observed spread minus fundamental spread, and the latter cannot fall below a fraction of the long-term spread for the category concerned. The practical consequence is counterintuitive and worth remembering: in a period of spread tightening, the fundamental spread can absorb nearly all of the observed spread, so the benefit of the mechanism shrinks sharply at the very moment the portfolio looks safest.
Portfolio of A-rated corporate bonds, duration 10, as of December 31, 2025. Observed spread 95 basis points, published fundamental spread 34 basis points, matching adjustment 61 basis points. As of December 31, 2022, in a stressed market, the same portfolio showed an observed spread of 210 basis points against a nearly unchanged fundamental spread, hence a 176 basis point adjustment: the mechanism gives most when markets are worst.
fundamental spread, part défaut du spread, coût du déclassement, spread de crédit non appropriable