An analyst evaluates two corporate bonds, both rated BB by the same rating agency, both with a 5% annual probability of default. The analyst weights them equally in a credit portfolio. What critical factor is the analyst likely ignoring?
AThe bonds may have different maturities, which affects duration risk but not credit expected loss
BBB-rated bonds always have identical recovery rates within the same rating category
CThe bonds may have different seniority levels, which affects loss given default (LGD) and therefore expected losses even with equal PD
DExpected loss only depends on PD; recovery rates are a separate accounting concern
Expected loss = PD × LGD × EAD. Two bonds with identical PD but different seniority have very different LGDs: senior secured creditors typically recover 60–80 cents on the dollar, while subordinated creditors recover 20–30 cents. A BB-rated senior secured bond and a BB-rated subordinated bond have the same probability of default but dramatically different expected losses. Focusing only on credit ratings without decomposing PD and LGD leads to mispriced portfolios.
Question 2 Multiple Choice
A corporate bond's credit spread widens from 80 basis points to 300 basis points over a single month, while the company's rating-agency historical default rate for that rating category remains unchanged. What happens to the market-implied probability of default?
AIt stays unchanged — market-implied PD tracks historical default rates by definition
BIt increases — market-implied PD is derived from the credit spread and updates in real time as spreads change
CIt decreases — wider spreads indicate that investors demand more compensation, suggesting lower risk
DIt becomes undefined — market-implied PD cannot be compared to historical PD because they measure different things
Market-implied PD is extracted from the credit spread using the approximation PD ≈ spread / (1 - recovery rate). As the spread widens from 80 to 300 bps, the market-implied PD rises proportionally. This is precisely the forward-looking advantage of market-implied PD: it updates in real time as market participants reassess default risk, while historical rating-agency default rates are backward-looking averages that change slowly. The two measures can diverge significantly during periods of market stress.
Question 3 True / False
A secured senior bondholder typically recovers a higher fraction of their investment after a default than an unsecured subordinated bondholder, because seniority determines the order of claims on the defaulting firm's assets.
TTrue
FFalse
Answer: True
Seniority governs the waterfall of claims in bankruptcy: secured senior creditors are paid first (typically recovering 60–80 cents on the dollar), followed by unsecured senior creditors (40–50 cents), then subordinated creditors (20–30 cents), with equity holders often receiving nothing. This ordering is why LGD differs systematically by seniority: higher seniority means lower LGD (higher recovery), which means lower expected loss even at the same PD.
Question 4 True / False
Market-implied default probabilities are typically preferable to historical default rates because they are more accurate and forward-looking.
TTrue
FFalse
Answer: False
Market-implied PD has the advantage of being forward-looking and updating in real time — it reflects current market sentiment about default risk. But it is also volatile, can be distorted by liquidity premiums and risk aversion (spreads can widen due to market fear, not just actual default risk), and requires assumptions about recovery rates to compute. Historical default rates are backward-looking and slower to update, but they are more stable and based on actual observed defaults. Neither is universally superior — analysts use both, recognizing their complementary strengths and limitations.
Question 5 Short Answer
Explain why two bonds with the same credit rating and the same probability of default can have different expected losses, and identify the key factor that explains the difference.
Think about your answer, then reveal below.
Model answer: Expected loss = PD × LGD × EAD. If two bonds have the same PD and the same exposure (EAD), expected loss still differs if LGD differs. LGD equals one minus the recovery rate, and recovery rates vary significantly by seniority: senior secured bonds recover 60–80% while subordinated bonds recover 20–30%. A BB-rated senior secured bond and a BB-rated subordinated bond have the same PD but very different expected losses. Seniority is the key factor — it determines how much lenders actually lose in a default, which is what LGD captures.
This is one of the most practically important insights in credit analysis. Credit ratings summarize default probability but do not fully capture expected loss, because they do not indicate seniority or recovery rates. Portfolio managers and loan pricers must decompose credit risk into its three components (PD, LGD, EAD) rather than relying on ratings alone. Two bonds with the same rating can have very different risk profiles depending on where they sit in the capital structure.