Fixed Income B: Analysis and Risk

• Topic 01

  Duration and Convexity

  39 questions
• Topic 02

  Term Structure Theories

  52 questions
• Topic 03

  Credit Analysis: Corporate Bonds

  42 questions
• Topic 04

  Introduction to Credit Default Swaps

  36 questions
• Topic 05

  Sovereign Debt Analysis

  27 questions
• Topic 06

  Fixed Income Portfolio Management Overview

  27 questions
• Topic 07

  Liability-Driven Investing and Immunisation

  24 questions
• Topic 08

  Interest Rate Risk Management

  34 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. A credit analyst is evaluating a leveraged buyout candidate. The company has total debt of \$800 million and EBITDA of \$120 million. The analyst notes the company operates in a highly cyclical industry with significant customer concentration. Which component of the four Cs framework BEST captures the concern about industry cyclicality and customer concentration?

   • A
     Character
   • B
     Capacity
     Correct answer
   • C
     Covenants
   • D
     Collateral
   Explanation

   Capacity encompasses not only the current ability to service debt (measured by financial ratios like leverage) but also the stability and predictability of future cash flows. Industry cyclicality and customer concentration are key factors that can impair a company's future cash flow generation, directly affecting its capacity to repay. In this case, the leverage ratio ($\text{Debt/EBITDA} = 800/120 \approx 6.7\text{x}$) is already high, and the qualitative capacity risks from cyclicality and concentration compound the concern. Collateral addresses asset values, Character addresses management, and Covenants address contractual protections.

2. Country Z has: Debt/GDP = 90%, interest rate on debt (r) = 6%, nominal GDP growth rate (g) = 4%, current primary deficit = 1.5% of GDP. Using the debt sustainability condition, is Country Z's debt-to-GDP ratio stable, rising, or falling?

   • A
     Stable: the 90% debt/GDP is above the 60% SGP threshold, which automatically triggers austerity measures that stabilise the ratio
   • B
     Rising: the required primary surplus to stabilise debt is (r − g) × d = (6% − 4%) × 90% = 1.8% of GDP surplus; but Country Z runs a 1.5% primary deficit, so the gap is 3.3% of GDP, meaning the debt ratio will rise
     Correct answer
   • C
     Stable: the primary deficit of 1.5% is small relative to GDP and will be offset by economic growth
   • D
     Falling: the nominal GDP growth rate (4%) exceeds the interest rate on new debt (6%) minus the primary deficit, reducing the ratio
   Explanation

   Debt sustainability condition: the primary balance needed to stabilise d = (r − g) × d = (0.06 − 0.04) × 0.90 = 0.018 = 1.8% primary surplus. Country Z runs a 1.5% primary deficit (not a surplus), meaning its fiscal position is worse than the required stabilisation level by 1.5% + 1.8% = 3.3% of GDP. With each year, the debt/GDP ratio rises by approximately (interest payments exceeding growth + primary deficit). This is a classic unsustainable debt trajectory: r > g requires a primary surplus, but the country runs a deficit instead. The automatic SGP mechanism applies only to eurozone members and does not guarantee fiscal discipline.

3. In sovereign credit analysis, which statement BEST describes the characteristic of developed market sovereign debt?

   • A
     Developed market sovereign bonds (e.g., US Treasuries, German Bunds) are typically rated AAA or AA, considered risk-free in domestic currency, and serve as the benchmark for domestic credit spreads
     Correct answer
   • B
     Developed market sovereign bonds typically carry speculative-grade ratings and trade at significant spreads over risk-free rates
   • C
     Developed market sovereigns typically rely on IMF programme assistance to meet debt service obligations
   • D
     Developed market sovereign bonds are denominated primarily in foreign currencies to attract international investors
   Explanation

   Developed market (DM) sovereign bonds share key characteristics: (1) Typically rated AAA or AA by major rating agencies; (2) Considered effectively risk-free in local currency (can always repay by printing money with minimal inflation risk due to institutional credibility); (3) Serve as the benchmark from which corporate credit spreads are measured (e.g., US Treasuries are the global risk-free rate benchmark, German Bunds for eurozone). DM sovereigns issue primarily in their own currencies. IMF assistance is associated with EM sovereigns in balance of payments difficulty, not DM sovereigns.