Practice: Credit Risk

Fixed Income. 14 question(s) in this unit's pool (2 above the exam). Free up to ten a day; the coach picks which ones based on what you have already answered and when each is next due.

Fixed IncomeCredit Risk
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Today's practice

Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own explanation. Questions you have already answered correctly and confidently stay out of the way until they are due for review again.

Question 1Exam level

An analyst is evaluating a bond issuer's credit quality. She examines cash flow generation, debt-to-EBITDA ratio, and interest coverage ratio. Which of the 4 Cs of credit is she primarily assessing, most likely?

How sure are you?

Correct: B. The correct answer is Capacity.
A. Character sounds like the qualitative/overall assessment of management quality, which could include financial ratios. Character is specifically management integrity and history of debt repayment. Not quantitative financial ratios.
C. Covenants include financial maintenance tests (e.g., maintaining minimum coverage ratios), which are checked via ratio analysis. Covenants are contractual restrictions in the bond indenture. Measuring whether a company can service debt is a Capacity assessment, not a Covenant assessment.

Unit: credit-risk

Question 2Exam level

A bond currently rated BBB by S&P is downgraded to BB+. This downgrade is most likely described as an example of:

How sure are you?

Correct: B. The correct answer is Credit migration risk.
A. A downgrade sounds like something bad has happened to the credit, which candidates associate with 'default risk.'. Default risk materializing means the issuer actually failed to pay. A downgrade is a rating change, not a payment failure.
C. Spread duration risk involves price sensitivity to spread changes, and a downgrade widens spreads. Spread duration describes price sensitivity mechanics. The event described is the rating change itself. Credit migration risk.

Unit: credit-risk

Question 3Exam level

The expected loss on a bond is most likely calculated as:

How sure are you?

Correct: B. The correct answer is Probability of default × loss given default.
A. Bond price seems like the relevant monetary exposure to multiply by probability of default. Expected loss uses LGD (the fraction of exposure lost), not the full bond price. If recovery is 40%, you don't lose the full price.
C. LGD and recovery rate are related, and dividing seems like a formula operation. LGD = 1 − Recovery Rate; you do not divide by recovery rate. And expected loss requires PD as a multiplier.

Unit: credit-risk

Question 4Exam level

A bond indenture contains a provision that limits the issuer from paying dividends above a specified threshold without bondholder approval. This provision is most likely classified as a:

How sure are you?

Correct: B. The correct answer is Negative covenant.
A. 'Affirmative' sounds like a strong, active form of bondholder protection, which dividend restrictions seem to be. Affirmative covenants require the issuer to take action (do something positive). Negative covenants prohibit actions. Restricting dividends = prohibition = negative covenant.
C. Character involves management behavior, and how dividends are paid relates to management decisions. Character is the analyst's qualitative assessment of management integrity, not a contractual provision in the bond document.

Unit: credit-risk

Question 5Exam level

An investment-grade bond has a modified duration of 6.0 and a credit spread of 150 basis points. If the credit spread widens by 50 basis points, the approximate price change due to spread widening is closest to:

How sure are you?

Correct: B. The correct answer is −3.00%.
A. −0.83% comes from dividing the spread change (50 bps) by the current spread level (150 bps) then adjusting, a nonsensical operation candidates attempt when confused. Price change uses duration × change in yield, not the ratio of yield changes. The formula is −D × Δy.
C. −9.00% comes from 6.0 × 1.50% (mistakenly using the full credit spread of 150 bps instead of the change of 50 bps). The question asks for the price change due to spread WIDENING by 50 bps, not the total spread level. Always use the change, not the level.

Unit: credit-risk

Question 6Exam level

Which of the following is MOST likely a limitation of credit ratings issued by major rating agencies?

How sure are you?

Correct: B. The correct answer is Ratings may lag deterioration in an issuer's creditworthiness.
A. You might know that rating models use financial ratios and assume quantitative = model-only. Rating agencies explicitly incorporate qualitative factors: management quality, industry position, competitive environment. The 4 Cs framework is qualitative as much as quantitative.
C. If ratings are real-time, they'd be more reliable; candidates might assume this is a true characteristic they haven't heard is a limitation. This statement is false. Ratings are NOT updated continuously. Real-time updating would actually be a positive feature, not a limitation.

Unit: credit-risk

Question 7Exam level

A 'fallen angel' in the bond market most likely refers to a bond that:

How sure are you?

Correct: B. The correct answer is Was originally issued as investment grade but downgraded to speculative grade.
A. A default is the ultimate negative credit event, and falling from grace to default sounds like a 'fallen angel.'. Fallen angel has a specific technical definition: crossing the IG/HY rating boundary. A defaulted bond is not called a fallen angel.
C. Interest rate declines can cause bond restructuring, which could be confused with a credit deterioration. Coupon rates on existing bonds are fixed and do not change with interest rate movements. Fallen angel is strictly a credit rating event.

Unit: credit-risk

Question 8Exam level

When evaluating the character of a bond issuer, a credit analyst would MOST likely examine:

How sure are you?

Correct: B. The correct answer is Management's track record and history of debt repayment.
A. Liquidity ratios are part of credit analysis and could be seen as a measure of a company's financial 'character.'. Liquidity ratios (current ratio, quick ratio) assess the ability to pay short-term obligations. This is Capacity, specifically short-term capacity.
C. Debt covenants relate to how the borrower is constrained in their behavior, which overlaps conceptually with trustworthiness. Covenants are contractual provisions in the bond indenture. That is the Covenants C. Character is about management's track record independent of formal contractual constraints.

Unit: credit-risk

Question 9Harder

Senior secured bondholders of a company that has filed for bankruptcy would MOST likely receive a higher recovery rate than:

How sure are you?

Correct: B. The correct answer is Senior unsecured bondholders.
A. Trade creditors (suppliers) are often seen as smaller and less powerful, implying they might recover less. Trade creditors are typically senior unsecured creditors. Their recovery is similar to or ahead of subordinated bonds. The question is specifically about secured vs unsecured bondholders.
C. Tax authorities seem like they would have lower claim than a contractual bondholder. Government tax claims often have super-priority status in bankruptcy. They can rank ahead of most private creditors under bankruptcy law.

Unit: credit-risk

Question 10Exam level

The credit spread on a corporate bond primarily compensates investors for, most likely:

How sure are you?

Correct: C. The correct answer is Expected loss from default and the risk premium for uncertainty around that loss.
A. Credit spreads are part of a bond's total yield, and interest rate risk is a bond risk, so candidates link them. Interest rate risk is compensated by the risk-free rate (government bond yield). The spread is the additional yield ABOVE the risk-free rate and compensates specifically for credit, not rate, risk.
B. Liquidity risk and credit risk are both common bond risks, and this answer lists two real components. While partially correct, this answer omits the uncertainty/risk premium component. The CFA curriculum defines the spread as compensating for expected loss PLUS the risk premium on that loss. Option C is more complete.

Unit: credit-risk

Question 11Exam level

A company's bonds are trading at a yield spread of 200 bps over comparable Treasury bonds. The company then reports weaker-than-expected earnings and its coverage ratios deteriorate significantly. Which of the following outcomes is MOST consistent with this development?

How sure are you?

Correct: A. The correct answer is The credit spread widens as credit risk increases.
B. Students who think credit spread only moves at the point of default will choose unchanged until default actually happens. Credit spreads are forward-looking market prices that move with changes in perceived default probability. They do not wait for an actual default.
C. Bond indenture coupons are fixed, so students may assume bond prices are also 'fixed.'. Bond prices change continuously in secondary markets. Rising yields (from wider spreads) cause bond prices to fall. The inverse price-yield relationship.

Unit: credit-risk

Question 12Harder

Which of the following bonds would MOST likely have the highest recovery rate in the event of issuer default?

How sure are you?

Correct: B. The correct answer is First mortgage bonds backed by real property.
A. 'Senior' in the name implies high priority, so 'senior subordinated' might sound senior enough. Senior subordinated is a contradictory name that actually ranks BELOW senior unsecured. These bonds are subordinated to senior debt. No collateral means lower recovery than secured bonds.
C. Convertible bonds have an equity option that could add value, potentially improving recovery. The conversion option has no value in default (equity is worthless in liquidation). Subordination means lower priority claims. Recovery is low.

Unit: credit-risk

Question 13Above the exam

Bond Issuer X has a lower probability of default than Bond Issuer Y over the next year, but Issuer X's bonds are unsecured while Issuer Y's bonds are secured by specific collateral with a loss-given-default estimated at only 20% (versus 60% for Issuer X's unsecured bonds). Combining probability of default with loss given default, the bond with the higher overall expected loss is most likely:

How sure are you?

Correct: B. Expected loss combines BOTH probability of default (POD) and loss given default (LGD): Expected loss = POD x LGD. A bond with a lower POD can still have a HIGHER expected loss than a bond with a higher POD if its LGD is disproportionately larger (as with Issuer X's unsecured status producing a 60% LGD versus Issuer Y's secured 20% LGD); the two components must be combined, not evaluated in isolation, to determine which bond carries more overall credit risk in expected-loss terms.
A. Probability of default alone does not determine expected loss; the RECOVERY characteristics of the bond (captured by loss given default) are an equally necessary second input, and ignoring LGD here specifically misses why Issuer X's unsecured, high-LGD bond could actually carry the higher expected loss despite its lower default probability.
C. Unsecured status raises LGD (lower recovery in default) but does not automatically make a bond riskier in EVERY respect, including probability of default itself, which the question states is LOWER for Issuer X; expected loss requires combining both POD and LGD, not assuming one characteristic dominates every dimension of credit risk.

Unit: credit-risk

Question 14Above the exam

A corporate bond's credit spread widens from 100 bps to 160 bps over a period during which the issuer's fundamental credit quality (leverage, coverage ratios, business risk) is unchanged, but overall market risk aversion has increased sharply (a 'flight to quality'). Combining the components of a credit spread with this scenario, the spread widening is most likely primarily attributable to:

How sure are you?

Correct: B. A credit spread reflects more than just the issuer-specific expected loss; it also includes compensation for liquidity risk and the market's general risk appetite (a market-wide risk premium that can move for reasons unrelated to any one issuer). Since the question specifically states the issuer's own fundamental credit quality is unchanged while market-wide risk aversion has increased, the spread widening most likely reflects this market-wide component, not a genuine change in the issuer's own default or recovery outlook.
A. The question explicitly states the issuer's fundamental credit quality (leverage, coverage, business risk) is UNCHANGED; attributing the spread widening to a genuine deterioration in issuer-specific expected loss directly contradicts that stated premise.
C. A bond's coupon rate is typically fixed at issuance and does not change over the bond's life for a standard fixed-rate bond; coupon changes are not a driver of credit spread movements at all in this context, market perception of risk is.

Unit: credit-risk