CFA Level II ExamFixed IncomeEasy
A portfolio manager is evaluating the credit risk of two corporate bonds: Bond Alpha and Bond Beta. Both bonds have the same maturity, coupon rate, and issuer. Bond Alpha is a senior secured bond, while Bond Beta is a senior unsecured bond. Which of the following statements is most accurate regarding their expected loss and recovery rates?
- ABoth bonds will have the same expected loss but Bond Alpha will have a higher recovery rate.
- BBond Alpha will have a higher expected loss and a lower recovery rate than Bond Beta.
- CBoth bonds will have the same recovery rate but Bond Alpha will have a lower expected loss.
- DBond Alpha will have a lower expected loss and a higher recovery rate than Bond Beta.
Show answer & explanationAnswer & explanation
Correct answer: D. Bond Alpha will have a lower expected loss and a higher recovery rate than Bond Beta.
Senior secured debt has a higher priority claim on the issuer's assets in the event of default, leading to a higher recovery rate. A higher recovery rate directly translates to a lower expected loss, assuming the probability of default is the same for both bonds.
Why the other options are wrong
- A. The expected loss will differ due to the difference in recovery rates, even with the same probability of default.
- B. This statement incorrectly reverses the relationship between seniority, recovery, and expected loss.
- C. Recovery rates will differ based on the security and seniority of the debt.
Seniority and Recovery Rates
The position of a debt claim in the event of an issuer's bankruptcy or liquidation, which directly impacts its recovery rate.
- Senior secured debt has the highest claim priority.
- Higher seniority typically leads to higher recovery rates.
- Higher recovery rates result in lower expected loss, all else equal.
Memory trick: Security and Seniority Secure Superior Settlements.