FRM Part II · FRM Exam Part II · The Global Drivers of Private Credit
A fund has a liability-driven target return of 6.0%. Public investment-grade bonds yield 3.5%, public high-yield bonds yield 6.0% with 25% annualised volatility of mark-to-market returns, and private loans yield 6.0% with reported volatility of 8% due to infrequent appraisal-based valuation. A risk analyst warns the committee about comparing the two on reported volatility. What is the core issue?
The issue is valuation smoothing. Infrequent appraisal-based marks understate private credit's true volatility and correlation with markets, so its risk-adjusted appeal looks better than public high yield with the same yield; returns should be unsmoothed before comparison.
- ASmoothed valuations understate private credit's true risk, so its risk-adjusted appeal is overstated relative to public high yieldCorrect
- BPrivate loans always have higher true volatility than high-yield bonds by construction of the coupon
- CHigh-yield bonds cannot meet the 6.0% target because of their coupon structure
- DReported volatility is overstated for private loans because of daily pricing
Explanation
Appraisal-based marks lag market conditions and dampen measured volatility and correlations, making private credit look safer per unit of yield. Adjusting for smoothing (for example unsmoothing returns) is needed for a fair comparison. Option 'always higher' is unsupported, and the loans are not priced daily.
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