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FRM Part II · FRM Exam Part II · The Rise and Risks of Private Credit

A fund of funds allocates to private credit. Its manager notes that during a period of rising policy rates, many direct lending borrowers' interest coverage ratios declined even though the loans are floating-rate and lenders' income rose. Which risk best explains this observation?

Higher policy rates raise floating-rate coupons, boosting lender income but lowering borrowers' interest coverage and increasing default risk. Floating-rate exposure thus shifts interest rate risk into credit risk rather than eliminating it.

  1. ABorrower credit risk rises because higher floating-rate interest burdens reduce coverage, creating a trade-off with higher lender incomeCorrect
  2. BLender interest rate risk rises because floating-rate loans lose value when rates rise
  3. CCurrency risk, because floating-rate loans are denominated in several currencies
  4. DPrepayment risk, because borrowers always refinance when rates rise

Explanation

Floating-rate coupons reset higher, raising lender income but also borrower debt service, which lowers interest coverage and raises default risk. Lender duration risk is small for floating-rate loans. Refinancing is less attractive when rates rise, so prepayment is not the explanation.

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