Credit risk and spreads

Credit risk and spreads

1. 1. A bond has annual default probability 2% and recovery rate 30%. What is the approximate fair credit spread over Treasury (basis points)? Use the approximation spread ≈ p · (1 − δ).

   bps

2. 2. Which rating boundary is the most operationally important because many institutional investors are forbidden by mandate from holding bonds below it?

   AAA vs AABBB- vs BB+ (investment grade vs speculative)B vs CCCA vs BBB

3. 3. Which of the following tend to widen credit spreads?

   Recession / rising default ratesLower investor risk appetiteFalling firm leverageTighter monetary policy hurting cyclical firms

4. 4. If high-yield spreads jumped from 250 bps to 1,000 bps during a financial crisis, what's the most accurate interpretation?

   Expected default losses alone widened 750 bpsBoth expected default losses AND the risk premium investors demand both roseDefault probabilities fell, but recovery rates roseTreasury yields fell by 750 bps