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

A private credit fund lends to mid-sized firms through floating-rate senior loans. Central banks raise policy rates by 300 basis points. Which outcome best describes the credit risk effect on the fund's portfolio?

Higher policy rates raise the coupons borrowers pay on floating-rate loans, lowering interest coverage and increasing default risk. The lender's interest rate risk is reduced, but it is transformed into credit risk, so rising fund income can coincide with deteriorating portfolio quality.

  1. AHigher coupon income reduces borrower interest coverage, raising default risk even as fund income risesCorrect
  2. BFloating-rate structure eliminates credit risk because interest adjusts automatically
  3. CBorrower interest coverage improves because coupon payments rise
  4. DDefault risk falls because senior loans are covered by covenants

Explanation

Floating-rate loans pass higher rates to borrowers, increasing debt service burdens and lowering interest coverage ratios, particularly for leveraged mid-sized borrowers. Interest rate risk for the lender is reduced but converts into credit risk. Covenants help but do not remove the effect.

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