READING 60 CREDIT RISK

Question 1

Which of the following best describes credit risk?

A. The risk that a bond’s price will fluctuate due to changes in interest rates
B. The risk that the borrower will fail to make timely payments of interest or principal
C. The risk of liquidity in the secondary bond market

Answer 1

Correct Answer: B

Explanation:

Credit risk is the risk that the borrower will fail to meet interest or principal payments, known as “servicing the debt.”

A refers to interest rate risk, not credit risk.

C refers to liquidity risk, which is different from credit risk.

Question 2

Which of the following most accurately describes a borrower who is insolvent?
A. Unable to convert assets into cash to pay obligations
B. Has total assets that exceed the value of outstanding debt
C. Has total assets that are less than its liabilities

Answer 2

Correct Answer: C

Explanation:

Insolvency occurs when the value of the borrower’s total assets is less than their total debt.

A describes illiquidity, not insolvency.

B describes a solvent condition.

Question 3

Which of the following is NOT considered one of the “5 Cs” in bottom-up credit analysis?

A. Country
B. Collateral
C. Covenants

Answer 3

Correct Answer: A

Explanation:

Country is a top-down factor, not part of the traditional “5 Cs.”

Collateral and Covenants are both part of the 5 Cs: Capacity, Capital, Collateral, Covenants, and Character.

Question 4

The “Capacity” component of credit analysis primarily refers to:
A. The borrower’s legal obligations
B. The borrower’s integrity and willingness to pay
C. The borrower’s ability to generate cash flow to make payments

Answer 4

Correct Answer: C

Explanation:

Capacity is about the borrower’s financial ability to make timely payments.

A relates more to covenants.

B refers to Character, another “C.”

Question 5

Which of the following best describes the Collateral component of credit analysis?
A. The borrower’s overall financial condition
B. Assets pledged to secure a debt
C. The issuer’s reputation for repaying past debts

Answer 5

Correct Answer: B

Explanation:

Collateral provides lenders with a backup source of repayment in case of default.

A is too general and could describe Capacity or Capital.

C refers to Character.

Question 6

A borrower is said to be in default when:
A. The market value of its bond falls below par
B. It fails to make a scheduled interest or principal payment
C. It violates a bond covenant without missing a payment

Answer 6

Correct Answer: B

Explanation:

A borrower is in default when it fails to service its debt (pay interest or principal).

A is a market reaction, not default.

C may lead to technical default but is not automatically considered payment default.

Question 7

Which factor is top-down in nature?

A. Character
B. Country
C. Capital

Answer 7

Correct Answer: B

Explanation:

Country refers to geopolitical and legal systems affecting credit risk—clearly top-down.

Character and Capital are bottom-up borrower-specific factors.

Question 7

Which of the following best describes a pari passu clause?
A. All bondholders have the same collateral rights
B. A default on one bond results in default on all others
C. Bondholders of the same class are treated equally in the event of default

Answer 7

Correct Answer: C

Explanation:

A pari passu clause ensures equal treatment among bondholders of the same rank.

A is incorrect; not all bonds have collateral.

B refers to a cross-default clause.

Question 8

Which of the following scenarios illustrates a cross-default clause?

A. A borrower defaults on one bond and this triggers default status on others
B. Two bonds are ranked equally in the liquidation process
C. All assets are pledged as collateral to multiple bondholders

Answer 8

Correct Answer: A

Explanation:

A cross-default clause causes a chain reaction of default across different bond issues.

B refers to pari passu.

C relates more to collateral arrangements.

Question 9

A government bond’s credit risk primarily stems from:

A. Volatility in the company’s cash flows
B. Excessive competition in the market
C. Fiscal deficits and political uncertainty

Answer 9

Correct Answer: C

Explanation:

Sovereign risk is influenced by fiscal health and political environment.

A and B apply more to corporate issuers.

Question 9

The “Character” component of credit analysis assesses:

A. The borrower’s ability to generate cash flow
B. The borrower’s past behavior and commitment to repay
C. Legal rights of the lender in case of default

Answer 9

Correct Answer: B

Explanation:

Character looks at management’s integrity, honesty, and payment history.

A refers to Capacity.

C relates to Covenants.

Question 10

Which of the following is an example of secondary cash flow for an unsecured corporate bond?
A. Net operating income
B. Sale of a subsidiary
C. Receivables from customers

Answer 10

Correct Answer: B

Explanation:

Selling a subsidiary is a secondary source of repayment if operating income isn’t enough.

A is a primary source.

C is part of operating income.

Question 11

Which condition would most likely increase the credit risk of a corporate issuer?

A. Strong profitability and low leverage
B. Declining revenue and rising debt levels
C. High operating margins and stable cash flows

Answer 11

Correct Answer: B

Explanation:

Poor revenue and high debt increase default risk.

A and C indicate strong financial health.

Question 12

What distinguishes secured debt from unsecured debt?

A. Secured debt cannot default under normal conditions
B. Secured debt has legal claims on specific pledged assets
C. Unsecured debt always pays a higher coupon

Answer 12

Correct Answer: B

Explanation:

Secured debt is backed by specific assets as collateral.

A is false—secured debt can default.

C is generally true, but not always and is not a defining feature.

Question 13

Currency risk is especially relevant when:

A. A firm issues debt in its local currency
B. A sovereign issues debt in foreign currency
C. The bond market is highly liquid

Answer 13

Correct Answer: B

Explanation:

A sovereign issuing in foreign currency faces repayment risk due to FX fluctuations.

A avoids currency risk.

C is unrelated.

Question 14

Which of the following is most likely to be considered capital in credit analysis?

A. Accounts payable
B. Shareholders’ equity
C. Inventory held for sale

Answer 14

Correct Answer: B

Explanation:

Capital includes resources like equity, which reduce dependence on debt.

A is a liability.

C is an asset but not considered capital for creditworthiness.

Question 15

In the event of a default, which bondholder is most at risk of suffering a credit loss?

A. A secured lender with collateral valued below outstanding debt
B. An unsecured bondholder with cross-default and pari passu clauses
C. A secured lender with full collateral coverage

Answer 15

Correct Answer: A

Explanation:

If collateral is insufficient, secured bondholders can still suffer losses.

B has access to general assets and equal ranking.

C is well protected.

Question 16

Which of the following is the correct formula for calculating expected loss from credit risk?
A. Expected loss = loss severity × recovery rate
B. Expected loss = probability of default × loss given default
C. Expected loss = credit spread × risk-free rate

Answer 16

Correct Answer: B

Explanation:

B is correct: Expected loss is calculated as the product of probability of default and loss given default.

A is incorrect: Loss severity is 1 – recovery rate, and this formula doesn’t represent expected loss.

C is incorrect: Credit spread is used for pricing, not calculating expected loss.

Question 17

Which of the following best defines “loss given default” (LGD)?
A. The annualized yield on a risky bond
B. The percentage of claim not recovered in the event of default
C. The price difference between a corporate bond and a government bond

Answer 17

Correct Answer: B

Explanation:

B is correct: LGD represents the portion of the investment that is lost if a borrower defaults.

A is incorrect: This refers to bond yield, not LGD.

C is incorrect: This describes credit spread, not LGD.

Question 18

What does the recovery rate represent?
A. The rate at which a bond’s price will recover after a downturn
B. The portion of the total exposure an investor recovers after default
C. The amount of coupon received before maturity

Answer 18

Correct Answer: B

Explanation:

B is correct: The recovery rate is the percentage of the claim an investor gets back after a default.

A is incorrect: This misinterprets the recovery rate as a market behavior metric.

C is incorrect: Coupons are unrelated to the recovery rate post-default.

Question 19

Which of the following metrics is most relevant when assessing probability of default?
A. Recovery rate
B. Interest coverage ratio
C. Bond duration

Answer 19

Correct Answer: B

Explanation:

B is correct: The interest coverage ratio (EBIT/interest expense) helps evaluate the firm’s ability to meet interest payments, affecting default probability.

A is incorrect: Recovery rate affects loss if default occurs, not its probability.

C is incorrect: Duration measures interest rate sensitivity, not credit risk.

Question 20

A bond is said to have high credit quality if it has:
A. Low interest coverage ratio and high debt/EBITDA
B. High EBIT margin and high cash flow to net debt ratio
C. High duration and low recovery rate

Answer 20

Correct Answer: B

Explanation:

B is correct: High EBIT margin and strong cash flow compared to debt suggest strong ability to repay, indicating high credit quality.

A is incorrect: These are signs of weak credit metrics.

C is incorrect: Duration and recovery rate don’t define credit quality directly.

Question 21

Loss severity is best defined as:
A. Recovery rate minus the coupon rate
B. The coupon income not received during default
C. One minus the recovery rate

Answer 21

Correct Answer: C

Explanation:

C is correct: Loss severity = 1 – recovery rate; it represents the percentage of loss if default occurs.

A is incorrect: This is not a defined relationship.

B is incorrect: Loss severity refers to principal loss, not coupon income.

Question 22

Which of the following best explains why secured, senior debt tends to have lower loss given default?
A. It earns higher returns
B. It is the first to be paid in bankruptcy
C. It has shorter maturities

Answer 22

Correct Answer: B

Explanation:

B is correct: Senior and secured creditors are prioritized during liquidation, reducing loss.

A is incorrect: Higher returns are not the reason; they may result from higher risk.

C is incorrect: Maturity doesn’t directly determine LGD.

Question 23

Which type of bond might experience lower losses in default, despite having higher probability of default? A. Investment-grade unsecured bond B. High-yield secured bond C. Government bond

Answer 23

Correct Answer: B Explanation: B is correct: High-yield bonds may be secured and recover more in default despite their higher risk of default. A is incorrect: While safer, if unsecured, recovery might be lower. C is incorrect: Government bonds have minimal default risk and aren't relevant in this context.

Question 24

If the actual credit spread of a bond is greater than its estimated credit spread, what does this imply? A. The bond is overpriced B. Investors are undercompensated C. Investors are more than fairly compensated

Answer 24

Correct Answer: C Explanation: C is correct: A higher actual spread suggests the investor is earning more than the fair level for taking on the credit risk. A is incorrect: The bond would be underpriced, not overpriced. B is incorrect: They’re overcompensated, not undercompensated.

Question 25

The expected exposure at default refers to: A. The market value of the bond at issue B. The amount owed minus collateral value C. The maximum loss in default

Answer 25

Correct Answer: B Explanation: B is correct: Expected exposure is the amount owed (principal + interest) minus any value of collateral. A is incorrect: Market value at issuance isn’t related to exposure in default. C is incorrect: It’s the basis for loss, not the loss itself.

Question 26

Credit spreads reflect compensation for: A. Interest rate volatility B. Credit risk relative to a risk-free benchmark C. Currency translation losses

Answer 26

Correct Answer: B Explanation: B is correct: Credit spreads measure the yield premium over risk-free securities to compensate for default risk. A is incorrect: That is interest rate risk. C is incorrect: Currency risk is not priced in via credit spreads.

Question 27

When assessing default probability, which of the following is least likely used? A. EBIT margin B. Bond duration C. Debt/EBITDA

Answer 27

Correct Answer: B Explanation: B is correct: Duration relates to interest rate risk, not credit risk. A and C are both financial ratios used to assess repayment ability and default probability.

Question 28

Which of the following best estimates the fair credit spread an investor should demand? A. Recovery rate × yield B. Probability of default × LGD% C. Interest coverage ratio / recovery rate

Answer 28

Correct Answer: B Explanation: B is correct: The expected credit loss (PD × LGD%) estimates the fair credit spread. A is incorrect: This is a meaningless combination. C is incorrect: Not a recognized method to estimate spread.

Question 29

Why might unsecured bonds from investment-grade issuers still carry material credit risk? A. Because they always have higher yields B. Because loss severity is very high in all investment-grade debt C. Because default probability could rise if the issuer’s financial condition weakens

Answer 29

Correct Answer: C Explanation: C is correct: Even investment-grade companies can become riskier over time, increasing default probability. A is incorrect: Investment-grade bonds don’t always have high yields. B is incorrect: Loss severity may be moderate; the main risk is a rise in default probability.

Question 30

Which of the following is a primary use of credit ratings issued by rating agencies? A. Predicting short-term price movements of bonds B. Assessing the credit risk of issuers across industries and over time C. Determining the intrinsic value of a company’s equity

Answer 30

Correct Answer: B Explanation: Correct: Credit ratings help assess credit risk across industries and time periods, allowing investors to compare relative creditworthiness. Incorrect A: Credit ratings are not designed to track short-term market movements; market prices move faster. Incorrect C: Credit ratings pertain to debt instruments and issuer creditworthiness, not equity valuation.

Question 31

A downgrade in a bond's credit rating may most likely: A. Increase its market value B. Decrease its yield to maturity C. Trigger contractual clauses that require action

Answer 31

Correct Answer: C Explanation: Correct: A downgrade can activate covenants in contracts such as collateral requirements or refinancing restrictions. Incorrect A: Downgrades increase risk, which usually causes a decline in market value. Incorrect B: Yields generally increase (not decrease) after downgrades as investors demand higher compensation for risk.

Question 32

Which of the following best explains why two bonds with the same rating may trade at different yields? A. Credit ratings reflect real-time market sentiment B. Market pricing incorporates default timing and expected recovery C. Credit ratings fully account for future liquidity risk

Answer 32

Correct Answer: B Explanation: Correct: Market pricing factors in additional real-time elements like timing of default and recovery expectations, which credit ratings do not fully capture. Incorrect A: Ratings are slow to adjust and lag behind real-time sentiment. Incorrect C: Liquidity is difficult to measure and not fully captured in ratings.

Question 33

Which of the following most accurately describes investment-grade bonds? A. Rated Ba1/BB+ or lower B. Rated BBB−/Baa3 or higher C. Rated A or higher only

Answer 33

Correct Answer: B Explanation: Correct: Bonds rated BBB− (S&P/Fitch) or Baa3 (Moody’s) or higher are classified as investment grade. Incorrect A: This describes non-investment grade (also called speculative or high-yield). Incorrect C: While A or higher is investment grade, this excludes the lower range of investment-grade bonds like BBB−.

Question 34

A key limitation of relying solely on credit ratings is: A. Ratings always overstate bond default probabilities B. Credit ratings reflect liquidity risk with high precision C. Ratings may lag behind market-based indicators

Answer 34

Correct Answer: C Explanation: Correct: Ratings are updated less frequently and can lag behind the fast-moving bond market. Incorrect A: Ratings may understate or overstate default probabilities depending on the situation, but not always. Incorrect B: Liquidity risk is complex and not fully reflected in ratings.

Question 35

Which of the following risks is least likely to be fully captured in credit ratings? A. Interest rate risk B. Litigation and natural disaster risk C. Relative credit risk across industries

Answer 35

Correct Answer: B Explanation: Correct: These risks are difficult to predict and often not incorporated fully into credit ratings. Incorrect A: Interest rate risk affects bond prices but is separate from credit risk; not the focus of ratings. Incorrect C: One main use of ratings is comparing credit risk across sectors and issuers.

Question 36

Which of the following is most accurate regarding bonds rated below investment grade? A. They are typically called treasury securities B. They are considered speculative or high-yield C. They have no default risk

Answer 36

Correct Answer: B Explanation: Correct: Bonds rated Ba1/BB+ or lower are considered speculative or high-yield (junk). Incorrect A: Treasury securities are government-issued and are not rated speculative. Incorrect C: All bonds carry some default risk, especially junk bonds.

Question 37

Why should investors not rely solely on credit ratings when assessing credit risk? A. Rating agencies provide real-time trading recommendations B. Ratings incorporate all macroeconomic and sector-specific data C. Ratings can be inaccurate or outdated

Answer 37

Correct Answer: C Explanation: Correct: Ratings may lag, be inaccurate, or miss sudden risks like fraud or market crashes. Incorrect A: Ratings assess credit risk, not short-term trading. Incorrect B: Ratings incorporate historical and forward-looking data, but not all real-time macro or sector-specific changes.

Question 38

Which of the following events most clearly demonstrates a limitation of credit rating agencies? A. The use of bonds to hedge interest rate risk B. The overrating of subprime securities before the 2008 crisis C. The classification of municipal bonds as tax-exempt

Answer 38

Correct Answer: B Explanation: Correct: A widely known failure was the inflated ratings on subprime securities, a key lesson in the limits of ratings. Incorrect A: This is a hedging technique, unrelated to rating agency limitations. Incorrect C: Tax-exempt status is a legal/tax issue, not a rating failure.

Question 39

What does a credit rating of D from S&P or Fitch indicate? A. The bond is speculative but not yet in default B. The bond is in default C. The bond is of the highest quality

Answer 39

Correct Answer: B Explanation: Correct: A D rating means the bond is in default — payments have not been made as agreed. Incorrect A: Speculative bonds are rated below investment grade, but not D. Incorrect C: Highest quality is AAA, not D.

Question 40

What does credit migration risk refer to? A. The risk that interest rates will change unexpectedly B. The risk that a bond is downgraded, reducing its value C. The chance a bond’s maturity will be extended

Answer 40

Correct Answer: B Explanation: Correct: Credit migration risk is the risk of a downgrade, which can lower a bond’s price and trigger clauses. Incorrect A: That’s interest rate risk, not credit migration. Incorrect C: Maturity extension risk is unrelated to ratings.

Question 41

Which of the following best explains why credit rating agencies might issue split ratings? A. Agencies use different assumptions and may weigh risks differently B. One agency always rates government bonds higher C. All rating agencies agree on credit risk analysis methods

Answer 41

Correct Answer: A Explanation: Correct: Agencies may differ in how they interpret uncertain risks (like lawsuits or M&A), leading to split ratings. Incorrect B: This is not a standard practice or cause of split ratings. Incorrect C: While there is overlap, agencies can and do use different models and views.

Question 42

Which of the following best describes credit spread risk? A. The risk that interest rates rise, causing bond prices to fall B. The risk that the yield spread of a bond widens due to deteriorating conditions C. The risk that the issuer defaults on a bond’s principal payments

Answer 42

Correct Answer: B Explanation: Credit spread risk is the risk that the yield spread (the difference between a risky bond’s yield and a risk-free bond’s yield) widens due to negative changes in credit conditions. A is incorrect: This describes interest rate risk, not credit spread risk. C is incorrect: This refers to default risk, which is related but not the same as spread risk.

Question 43

Why is credit spread risk a primary concern for investment grade bond investors? A. Because these bonds are most likely to default B. Because even small spread widening significantly affects their lower-yield bonds C. Because they typically trade in illiquid markets

Answer 43

Correct Answer: B Explanation: Investment grade bonds have low default risk, so the greater concern is spread widening due to perceived credit deterioration. This can significantly affect prices since they offer relatively lower yields. A is incorrect: Investment grade bonds have low default risk. C is incorrect: Investment grade bonds are generally more liquid, not less.

Question 44

Which of the following factors is not a common source of credit spread risk? A. Changes in the macroeconomic environment B. Issuer-specific financial difficulties C. Fluctuations in foreign exchange rates

Answer 44

Correct Answer: C Explanation: Credit spread risk stems from macroeconomic trends, issuer-specific issues, and market liquidity—not FX volatility. A and B are both directly mentioned as key sources of credit spread risk.

Question 45

During a recession, what typically happens to credit spreads? A. They contract as default risk decreases B. They remain unchanged due to government intervention C. They widen as default risk increases

Answer 45

Correct Answer: C Explanation: In recessions, default probability rises, leading to wider credit spreads as investors demand more return for increased risk. A is incorrect: Credit spreads contract in economic expansions, not recessions. B is incorrect: While intervention may help, spreads usually widen due to market forces.

Question 46

What is the expected shape of a credit spread curve in normal market conditions? A. Downward sloping B. Flat C. Upward sloping

Answer 46

Correct Answer: C Explanation: In normal conditions, longer-term bonds have higher credit risk, so spreads rise with maturity—creating an upward-sloping credit spread curve. A is incorrect: Inverted curves may occur during recessions. B is incorrect: Flat curves are not typical in healthy markets.

Question 47

What does an inverted high-yield credit spread curve typically signal? A. Near-term default risk is decreasing B. Near-term default risk is increasing C. Investors expect lower inflation

Answer 47

Correct Answer: B Explanation: An inverted credit spread curve suggests investors expect higher short-term risk, often signaling rising default risk in the near future. A is incorrect: Inversion means greater, not less, near-term risk. C is unrelated to credit spreads.

Question 48

Compared to investment grade spreads, high-yield spreads are: A. Lower and more stable B. Higher and more volatile C. Similar but with wider bid–offer spreads

Answer 48

Correct Answer: B Explanation: High-yield bonds have higher credit risk, so they offer higher spreads and exhibit more volatility in those spreads. A is incorrect: This describes investment grade bonds. C is partially true but does not fully address volatility and spread level.

Question 49

A "flight to quality" during a crisis typically leads to: A. Narrower high-yield spreads B. Lower demand for risk-free assets C. Widened spreads on high-yield bonds

Answer 49

Correct Answer: C Explanation: In crises, investors move from risky to safe assets (flight to quality), dumping high-yield bonds, which causes their spreads to widen sharply. A is incorrect: Spreads widen, not narrow. B is incorrect: Demand for safe assets increases, not decreases.

Question 50

Which of the following is true about bid–offer spreads during a financial crisis? A. They shrink due to improved market confidence B. They widen, especially for high-yield bonds C. They remain stable due to central bank action

Answer 50

Correct Answer: B Explanation: During financial stress, liquidity dries up, especially in riskier assets like high-yield bonds, leading to wider bid–offer spreads. A is incorrect: Crises increase uncertainty. C is possible, but spreads still typically widen due to reduced market making.

Question 51

Which of the following best describes the bid–offer spread? A. The gap between the coupon and market yield B. The difference between risk-free and risky yields C. The difference between the price a dealer will buy and sell a bond

Answer 51

Correct Answer: C Explanation: The bid–offer spread reflects the dealer’s willingness to buy (bid) and sell (offer) a bond. It’s a direct measure of liquidity cost. A and B describe other types of spreads (e.g., yield spread).

Question 52

Why do high-rated issuers typically have narrower bid–offer spreads? A. They offer higher coupon payments B. Their bonds are more actively traded C. They are less affected by interest rate changes

Answer 52

Correct Answer: B Explanation: More trading volume means better liquidity, allowing tighter bid–offer spreads for investment-grade issuers. A is incorrect: High-rated bonds often have lower coupons. C is related to interest rate risk, not bid–offer spreads.

Question 53

What factor would most likely cause market liquidity risk to increase? A. Increased bond issuance matched with rising demand B. Reduced market making activity by broker-dealers C. Stable macroeconomic conditions

Answer 53

Correct Answer: B Explanation: Less market making reduces available liquidity, leading to wider spreads and higher liquidity risk. A is incorrect: If demand matches issuance, liquidity is not harmed. C is incorrect: Stable macro conditions reduce liquidity risk.

Question 53

An issuer’s yield spread is higher than peers with the same credit rating. What does this most likely indicate? A. Inflation is increasing B. The issuer has stronger profitability C. There are issuer-specific concerns

Answer 53

Correct Answer: C Explanation: When a bond trades wider than others in its rating group, it usually reflects issuer-specific problems, like poor financials. A is incorrect: Inflation is a macro factor, not issuer-specific. B is incorrect: Strong performance would narrow the spread.

Question 54

Which of the following is most likely to result in a widening of yield spreads? A. Strong economic growth B. Rising default expectations C. Increased investor risk appetite

Answer 54

Correct Answer: B Explanation: Higher expected defaults make investors demand higher yields, widening spreads. A is incorrect: Growth typically narrows spreads. C is incorrect: More risk appetite reduces spreads.

Question 55

What does a wider bid–offer spread indicate? A. Low transaction costs B. High liquidity C. High market liquidity risk

Answer 55

Correct Answer: C Explanation: A wide spread means trading is costly and difficult—indicating poor liquidity. A is incorrect: Wider spreads mean higher, not lower, costs. B is incorrect: It’s the opposite—low liquidity.

Question 55

Why might a bond from a small issuer have higher market liquidity risk? A. The bond is usually rated investment grade B. There are fewer bonds outstanding and fewer trades C. The bond’s maturity is too short

Answer 55

Correct Answer: B Explanation: Smaller issuers have less outstanding debt, so fewer investors trade their bonds—resulting in poor liquidity. A is incorrect: Size, not rating, drives this liquidity issue. C is unrelated: Maturity does not directly affect liquidity.

Question 56

How can analysts estimate the liquidity component of a bond’s yield spread? A. Use the bond's rating and maturity B. Compare the yield at bid and offer prices C. Evaluate the bond’s coupon structure

Answer 56

Correct Answer: B Explanation: The yield difference between bid and offer reflects the liquidity risk premium in the spread. A is used for credit risk, not liquidity. C is unrelated.

Question 57

Which factor would most likely lead to credit spreads narrowing? A. Recession and rising unemployment B. Corporate earnings growth and economic expansion C. Falling liquidity and increased issuance

Answer 57

Correct Answer: B Explanation: Positive macro conditions reduce credit risk → spreads narrow. A is incorrect: These factors widen spreads. C is incorrect: Both increase risk.

Question 58

What is a common behavior of high-yield spreads during economic recoveries? A. They widen due to greater risk aversion B. They contract significantly, allowing capital gains C. They flatten as default probabilities rise

Answer 58

Correct Answer: B Explanation: During recovery, risk appetite increases, spreads narrow, and bond prices rise—offering capital appreciation. A is incorrect: That happens in a crisis, not recovery. C is incorrect: Default risk falls, not rises.

Question 59

Which of the following is most likely an incentive for investing in high-yield bonds? A. Guaranteed principal safety B. More stable prices in recessions C. Equity-like returns with diversification benefits

Answer 59

Correct Answer: C Explanation: High-yield bonds can provide higher returns and diversify portfolios since their price movements differ from investment grade bonds. A is incorrect: They are not guaranteed. B is incorrect: They are more volatile in downturns.

Question 60

How does heavy new issuance in bond markets affect spreads if not matched by demand? A. Spreads narrow due to investor optimism B. Spreads remain unchanged C. Spreads widen due to supply-demand imbalance

Answer 60

Correct Answer: C Explanation: If more bonds enter the market than investors are willing to buy, prices fall → spreads widen. A is incorrect: Optimism increases demand, not supply. B is incorrect: Supply-demand imbalance alters spreads.

Question 60

What happens to the credit spread curve of investment grade and high-yield bonds during a recession? A. It flattens or inverts B. It steepens dramatically C. It contracts due to better conditions

Answer 60

Correct Answer: A Explanation: In recessions, spreads rise, but near-term risk increases more, causing the curve to flatten or invert. B is incorrect: Steepening happens in recoveries. C is incorrect: Spreads expand, not contract.

Question 61

Why might increased regulations on bond dealers lead to wider spreads? A. Dealers are more efficient under regulation B. Regulations reduce the incentive to hold inventory C. Regulations increase the credit quality of issuers

Answer 61

Correct Answer: B Explanation: Regulations can raise costs for dealers to hold inventory, making them less willing to buy—this increases spreads. A is incorrect: Efficiency doesn’t necessarily increase. C is irrelevant to market making.

Question 62

Funding stress in bond markets most directly causes: A. Increased investor risk tolerance B. More demand for lower-rated debt C. Greater risk aversion and wider spreads

Answer 62

Correct Answer: C Explanation: When funding is tight, investors pull back, demand higher yields, and spreads widen. A is incorrect: Risk aversion rises, not tolerance. B is incorrect: Investors avoid risky debt in stress.

Question 63

Which component of yield spread reflects credit risk once liquidity risk is accounted for? A. Total spread over the benchmark B. Difference between coupon and market rate C. Residual spread after removing liquidity component

Answer 63

Correct Answer: C Explanation: After subtracting liquidity premium (from bid-offer yield diff), the residual is attributed to credit risk. A is incorrect: This includes both risks. B is unrelated.

Question 64

Which of the following best describes the relationship between liquidity and trading volume? A. Lower trading volume leads to lower liquidity B. Higher trading volume reduces bid–offer spreads C. Both A and B

Answer 64

Correct Answer: C Explanation: Bonds traded frequently are easier to buy/sell, leading to better liquidity and tighter spreads. A and B are both true individually.

Question 65

Which type of issuer is least likely to have a wide bid–offer spread? A. Low-rated, small-cap issuer B. Government-backed investment-grade issuer C. Start-up with minimal debt issuance

Answer 65

Correct Answer: B Explanation: Safe, liquid issuers attract more trading and market making—so spreads are narrow. A and C have low liquidity and credit quality.

Question 66

Why do credit spreads tend to rise with maturity? A. Long-term bonds have more liquidity B. Probability of default increases over time C. Short-term bonds are more volatile

Answer 66

Correct Answer: B Explanation: Longer duration = more uncertainty = higher chance of default → wider spreads. A is incorrect: Long-term liquidity may be worse. C is incorrect: Long-term bonds are usually more volatile.

Question 67

What does a flattening credit spread curve indicate? A. Improving issuer fundamentals B. Investors see greater risk in the short term C. Falling risk-free interest rates

Answer 67

Correct Answer: B Explanation: A flattening curve signals higher near-term risk expectations vs. long-term. A is incorrect: That would steepen the curve. C is unrelated to credit spread shape.

Question 68

In the context of credit spreads, what is “dispersion”? A. The difference between coupons and yields B. Variation in spreads across issuers of the same rating C. Change in interest rates across different bond maturities

Answer 68

Correct Answer: B Explanation: Dispersion reflects how much spreads vary among similar-rated issuers, usually higher for high-yield bonds. A and C are unrelated concepts.