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FRM Part II · FRM Exam Part II · The Global Drivers of Private Credit

A private credit fund lends to mid-sized firms at floating rates. Policy rates rise sharply by 300 basis points. Which is the most likely credit risk implication for the fund's portfolio?

Interest coverage deteriorates and default risk rises. Floating-rate borrowers pay more when policy rates rise, which strains cash flow. The fund's higher coupon income does not remove this credit risk, and seniority only affects recovery, not default probability.

  1. ABorrower interest coverage deteriorates, raising default risk, because floating-rate payments riseCorrect
  2. BDefault risk falls because lenders earn higher coupons
  3. CCredit risk is unchanged because the loans are senior secured
  4. DPrepayment risk becomes the dominant risk because borrowers want to refinance at higher rates

Explanation

Floating-rate borrowers face higher debt service when rates rise, which reduces interest coverage and raises default probability, even though the fund's coupon income rises. Higher coupons do not offset the borrower stress. Seniority affects recovery, not the rise in default probability. Refinancing at higher rates is unattractive, so prepayment is not dominant.

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