CFA Level II ExamFixed IncomeMedium
A credit analyst is assessing the credit risk of a manufacturing company. The company has recently experienced declining revenues and increasing leverage. The analyst observes that the company's bond yields have widened significantly relative to benchmark government bonds. Which of the following factors is LEAST likely to explain the widening credit spread?
- ADecreased market liquidity for the company's bonds.
- BFlight to quality by investors.
- CIncreased perceived probability of default.
- DLower expected loss given default (LGD) for the bonds.
Show answer & explanationAnswer & explanation
Correct answer: D. Lower expected loss given default (LGD) for the bonds.
A widening credit spread indicates higher perceived credit risk. A lower expected loss given default (LGD) would imply that investors expect to recover more in the event of default, which would generally lead to a narrower, not wider, credit spread. All other options contribute to widening credit spreads.
Why the other options are wrong
- A. Lower liquidity means investors demand a higher premium to hold the bond, widening the spread.
- B. During periods of uncertainty, investors may shift from riskier corporate bonds to safer government bonds, increasing demand for government bonds and decreasing demand for corporate bonds, thus widening corporate bond spreads.
- C. An increased probability of default directly increases credit risk and thus widens the spread.
Credit Spread Determinants
Credit spreads are the difference in yield between a credit-risky bond and a risk-free benchmark bond of similar maturity, reflecting various risk factors.
- Probability of Default (PD) increases spread.
- Loss Given Default (LGD) increases spread.
- Market liquidity risk increases spread.
- Systemic factors (e.g., flight to quality) increase spread.
Memory trick: PD, LGD, Liquidity, and Systemic fears widen the spread.