CFA Level II ExamFixed IncomeEasy
A portfolio manager is assessing the credit risk of two corporate bonds: Bond A, a senior secured bond, and Bond B, a subordinated unsecured bond, both issued by the same company. Which statement regarding their credit risk is most accurate?
- ABond A has lower credit risk than Bond B due to its higher priority in liquidation.
- BBond B has lower credit risk than Bond A because its coupon rate is typically higher.
- CBond A has higher credit risk than Bond B due to its fixed coupon payments.
- DBoth bonds have the same credit risk as they are issued by the same company.
Show answer & explanationAnswer & explanation
Correct answer: A. Bond A has lower credit risk than Bond B due to its higher priority in liquidation.
In the event of a company's liquidation, senior secured debt (Bond A) has the highest priority of claims on the company's assets, meaning it is repaid before subordinated unsecured debt (Bond B). This higher priority translates to lower credit risk for Bond A.
Why the other options are wrong
- B. Incorrect. Bond B (subordinated unsecured) typically has a higher coupon rate precisely because it carries higher credit risk, not lower.
- C. Incorrect. Fixed coupon payments do not inherently increase credit risk. Senior secured status reduces credit risk.
- D. Incorrect. While issued by the same company, the different seniority and security features mean they have different levels of credit risk.
Seniority and Security in Credit Risk
The seniority and security of a bond determine its priority of claims on a company's assets and cash flows in the event of default or liquidation, directly impacting its credit risk.
- Senior secured debt has the highest claim priority and lowest credit risk.
- Unsecured debt has general claims on assets, lower priority than secured.
- Subordinated debt has the lowest claim priority (after senior and unsecured) and highest credit risk.
Memory trick: Seniority is the 'ladder' of claims, higher rung means lower risk.