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Difficulty: MediumNon-Systematic and Credit Risks

An investor holds senior unsecured debentures issued by a retail corporation. Following consecutive quarters of declining earnings, a major credit rating agency downgrades the bond's credit rating from BBB to BB, citing concerns over the issuer's operational cash flows and debt service capability. Which of the following risks has primarily increased for the bondholder as a result of this downgrade?

  1. Credit risk, because the downgrade reflects an increased likelihood that the issuer may fail to make timely payments of interest or principal.Answer
  2. B
    Interest rate risk, because the downgrade causes prevailing market interest rates across the financial system to rise.
  3. C
    Systematic market risk, which can be eliminated entirely by diversifying into corporate bonds of other issuers within the same industry.
  4. D
    Reinvestment risk, because the rating downgrade guarantees that the investor will receive lower interest payments on short-term reinvestments.

Answer

Credit risk, because the downgrade reflects an increased likelihood that the issuer may fail to make timely payments of interest or principal.
Credit risk (also called default risk) measures the risk that an issuer will fail to make required interest or principal payments on its debt securities. Rating agency downgrades from investment grade (BBB) to speculative grade (BB) directly reflect an increased risk of default.

Step-by-Step Solution

1
Identify the nature of the corporate event described in the scenario.
The event is a credit rating downgrade (from BBB investment grade to BB speculative grade) driven by issuer-specific financial strain.
Credit ratings evaluate an issuer's financial strength and capacity to fulfill debt obligations on time.
2
Distinguish between non-systematic (issuer-specific) and systematic (market-wide) risk categories.
Credit/default risk is non-systematic risk unique to a single debt issuer, whereas interest rate risk affects all fixed-income securities broadly.
Operational challenges of a specific firm affect only that issuer's securities, making it a non-systematic risk.
3
Select the risk type directly evaluated by credit rating changes.
Credit risk is the primary risk that increases following a debt rating downgrade.
A downgrade below BBB indicates speculative grade status with higher default probability.

Key Concept

Credit risk (default risk) is non-systematic risk specific to an issuer's financial capacity to meet debt service obligations.
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Topics

Non-Systematic and Credit Risks

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