CFA Level I · CFA Level I Exam · Credit Risk
Which statement about recovery rates by seniority is most accurate? Bonds with a pledge of specific collateral, compared with otherwise identical unsecured bonds of the same issuer, most likely:
Collateralized bonds most likely have a lower credit spread because of higher expected recovery. Collateral affects loss given default rather than the probability of default, and a smaller expected loss means investors require less additional yield than on otherwise identical unsecured bonds.
- Ahave a lower credit spread because of higher expected recoveryCorrect
- Bhave the same probability of default and a lower recovery
- Chave a lower probability of default because of the collateral
Explanation
Collateral does not change the issuer's probability of default; it raises the amount recovered if default occurs. Higher expected recovery lowers expected loss, so the credit spread is lower. The second option has the recovery direction reversed.
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