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Difficulty: MediumNon-Systematic and Credit Risks

An investor holding U.S. Treasury bonds is concerned about macroeconomic inflation eroding purchasing power over time, whereas an investor holding high-yield bonds issued by a single retail corporation is concerned about the corporation failing to meet its scheduled principal and interest obligations due to weak sales. Which of the following best identifies the specific risk confronting the high-yield corporate bondholder, along with its key characteristic?

  1. Credit risk, which is a non-systematic risk specific to the financial stability of the issuer and can be mitigated through diversification.Answer
  2. B
    Interest rate risk, which is a systematic risk caused by fluctuating market yields and cannot be reduced by holding debt from different corporate issuers.
  3. C
    Market risk, which is a non-systematic risk inherent to all fixed-income instruments regardless of the issuer's financial condition.
  4. D
    Systematic credit risk, which affects all corporate and government bond issues equally during economic downturns and cannot be diversified.

Answer

Credit risk, which is a non-systematic risk specific to the financial stability of the issuer and can be mitigated through diversification.
Credit risk (also known as default risk) measures the probability that a debt issuer will fail to pay interest or repay principal as promised. Because this risk depends on the specific operational performance and financial strength of the individual issuer, it is classified as a non-systematic risk. A primary feature of non-systematic risk is that it can be significantly reduced through asset diversification.

Step-by-Step Solution

1
Analyze the concern described in the scenario for the high-yield corporate bondholder.
The investor is concerned about the issuer failing to meet its contractual principal and interest payments due to company-specific financial weakness.
Identifying the specific threat (issuer failure to pay) defines the type of risk involved.
2
Classify the risk as systematic or non-systematic.
Failure of a specific corporation to meet obligations is unique to that issuer, making it a non-systematic (unsystematic) risk.
Non-systematic risks stem from issuer-specific factors (such as business, credit, or operational challenges) rather than broad market forces.
3
Determine the mitigation strategy for this risk category.
Non-systematic risks can be substantially reduced or eliminated by diversifying investments across different issuers, sectors, and asset classes.
Diversification spreads exposure so that default by one single issuer does not severely impact the entire portfolio.

Key Concept

Credit Risk and Non-Systematic Risk Characteristics
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Topics

Non-Systematic and Credit Risks

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