Credit Risk - combining rating outlook with earnings surprise

CFA Level II Fixed Income
#1

This is a mock 2012 question so if you do not want to spoil it, leave it for later, else, please read on.

Question 49 of the afternoon session is bothering me a bit because the conclusions they arrive at are fairly vague, actually, not clear. Below are the deails. To me the combination of factors does not make sense. I can see why Andes would suffer from credit spread risk (based on earnings surprise), however, I do not see why Barranca would suffer from downgrade risk given the earnings surprise of +5%. It seems in one case they look at the earnings surprise and in the other they look at the rating outlook. I can kind of see the answer but I’m not that convinced. Any suggestions?

Andes Barranca Cuzco

credit rating Baa3, B1, Caa1

rating outlook positive, negative, stable

earnings surprise -15%, +5%, -2%

  1. Based on the information in Exhibit 1, the bonds issued by Andes, Barranca, and Cuzco,

respectively, most likely pose which of the following credit risks? A. Downgrade risk, credit spread risk, and default risk B. Credit spread risk, default risk, and downgrade risk C. Credit spread risk, downgrade risk, and default risk

C is correct because Andes is expected to report earnings well below expectations while its bonds trade at a tighter spread than comparable-rated bonds in the market. The higher credit risk posed by lower earnings likely will cause the spread to widen. Note that credit spread risk reflects the likelihood that the market will require a wider spread due to the perceived increase in risk. Barranca is the only credit of the three that carries a negative outlook, signaling that the rating agency may downgrade it in the intermediate term. Cuzco is the lowest rated credit in the group at Caa1, which empirically has a high probability of default.

#2

It’s a bit of an elimination question…

First off look at Cuzco…it has the worst current rating and -ve earnings surprise. so default risk makes sense.

So,we have a choice of answer A or C

Going to Andes, it has a +ve outlook and -ve earnings surprise…it is more likely to go to a nuetral outlook than downgraded risk…So credit spread makes kore sense.

From the process of elinination it looks like answer C.

Not a great question, but does make sense.

I have seen questions, that just don’t make sense even when you have the answer, this one isn’t one of those, thnkfully!

#3

“however, I do not see why Barranca would suffer from downgrade risk given the earnings surprise of +5%.”

I think the earnings surprise is supposed to be irrelevant to downgrade risk. Company B has downgrade risk because of the negative outlook. If the earnings surprise had any effect on downgrade risk, the negative outlook would change.

#4

This is correct. The Q is an elimination-style Q, although this one is perhaps the most counterintuitive of all three given.

#5

the answer is correct!!!

only Barranca has a negative outlook, and thus the only one with downgrade risk.

only Cuzco is a junk bond

negative earnings will push up the yields for the firm, as investors would get fearful.

Answer C