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

A private credit fund lends to middle-market borrowers using floating-rate loans. Policy rates rise by 300 bp over two years. Which outcome is the most plausible effect on the fund's credit risk?

Higher policy rates reset floating coupons upward, which lifts the fund's income per loan but squeezes borrowers' interest coverage. Leveraged middle-market borrowers are then more likely to default, so interest rate risk is converted into higher credit risk for the lender.

  1. ABorrower interest coverage falls, raising default risk even though the fund's interest income per loan risesCorrect
  2. BBorrower interest coverage rises because coupons reset higher
  3. CDefault risk falls because floating-rate loans have no duration
  4. DCredit risk is unaffected because loans are held to maturity

Explanation

Floating coupons rise with rates, increasing lender income but also borrower debt service burden. Highly levered borrowers see lower interest coverage ratios, raising default probability. Thus the interest rate risk is transformed into credit risk.

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