CFA Level I · CFA Level I Exam · Credit Risk
Which factor is most likely to increase loss severity, rather than probability of default, for a given issuer?
Becoming subordinated to new secured borrowing most likely raises loss severity. It lowers the bond's priority of claim, so recovery falls if default happens. Weaker interest coverage and a rating downgrade mainly point to a higher probability of default.
- AA weaker interest coverage ratio
- BA downgrade of the issuer's credit rating
- CA shift of debt priority so that the bond becomes subordinated to new secured borrowingCorrect
Explanation
Subordination to new secured debt reduces the bond's claim on assets in liquidation, lowering recovery and raising loss severity. Weaker coverage and a rating downgrade mainly signal a higher likelihood of default rather than a lower recovery.
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