Which of the following losses can be attributed to credit risk:

Which of the following losses can be attributed to credit risk:

I. Losses in a bond’s value from a credit downgrade

II. Losses in a bond’s value from an increase in bond yields

III. Losses arising from a bond issuer’s default

IV. Losses from an increase in corporate bond spreads
A . I, III and IV
B . II and IV
C . I and II
D . I and III

View Answer

Answer: D

Explanation:

Losses due to credit risk include the loss of value from credit migration and default events (which can be considered a migration to the ‘default’ category). Therefore Choice ‘d’ is the correct answer. Changes in spreads or interest rates are examples of market risk events. [Discussion: It may be argued that losses from spreads changing could be categorized as credit risk and not market risk. The distinction between credit and market risk is never really watertight.

The reason I have called it market risk in this question is because spreads can change due to two reasons: first, due to the individual issuer going down in their credit rating (whether issued or perceived, as we have witnessed in Europe sovereign debt), and second due to the spread for the overall category changing due to macro fundamentals with nothing changing for the individual issuer. For example the spread between municipal bonds and treasuries may be small during boom times and may expand during recessions – regardless of how the individual issuer has been doing. Clearly, the first case is credit risk and the second is probably market risk.

A change in overall corporate bond spreads is something I would consider akin to a rate change – which is why I have called it as not a part of credit risk. But an alternative perspective may not be incorrect either.]