B is correct. A surety bond is an external credit enhancement, i.e., a guarantee received from a third party. If the issuer defaults, the guarantor who provided the surety bond will reimburse investors for any losses, usually up to a maximum amount called the penal sum.
A is incorrect because covenants are legally enforceable rules that borrowers and lenders agree upon when the bond is issued. C is incorrect because overcollateralization is an internal, not external, credit enhancement. Collateral is a guarantee underlying the debt above and beyond the issuer's promise to pay, and overcollateralization refers to the process of posting more collateral than is needed to obtain or secure financing. Collateral, such as assets or securities pledged to ensure debt payments, is not provided by a third party. Thus, overcollateralization is not an external credit enhancement.
Q. A portfolio manager holds the following three bonds, which are option-free and have the indicated durations.
Bond Par Value Owned Market Value Owned Duration
A $8,000,000 $12,000,000 3
B $8,000,000 $6,000,000 7
C $4,000,000 $6,000,000 6
The portfolio's duration is closest to:
B is correct. Covenant analysis is especially important for high-yield credits because of their reduced margin of safety. Covenants are meant to protect creditors, and high-yield bonds are typically issued by companies with weak business profiles, which makes their risk of default higher relative to investment-grade bonds, which are typically issued by companies with strong business prospects. The increased likelihood of default for high-yield bonds relative to investment-grade bonds makes covenant analysis more important for high-yield investors compared with investment-grade investors.
A is incorrect because Liquidity is important for all issuers but is absolutely critical for high-yield issuers. Investment-grade companies typically have substantial cash on their balance sheets, generate a lot of cash from operations relative to their debt, and/or are presumed to have alternate sources of liquidity, such as bank lines and commercial paper. For these reasons, investment-grade companies can more easily refinance maturing debt. In contrast, high-yield companies may not have those options available, so having adequate cash on hand is essential.
C is incorrect because High-yield bonds are sometimes thought of as a "hybrid" between higher-quality bonds, such as investment-grade corporate debt, and equity securities. Their more volatile price and spread movements are less influenced by interest changes than are higher-quality bonds, and they show a greater correlation with movements in the equity markets.