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Difficulty: HardNon-Systematic and Credit Risks

An investor holds a dedicated fixed-income portfolio consisting entirely of long-term U.S. Treasury bonds with an average duration of 18 years. Following a sharp increase in benchmark market interest rates, the portfolio's market value declines by 15%. The investor contacts their financial advisor, expressing concern that the federal government might fail to meet its upcoming interest payment obligations. Which of the following statements accurately distinguishes the primary risk currently affecting the portfolio from the risk feared by the investor?

  1. The portfolio is currently impacted by interest rate risk (a systematic risk), whereas the investor's concern describes credit risk (a non-systematic risk that is virtually nonexistent for U.S. Treasury debt).Answer
  2. B
    The portfolio is currently impacted by credit risk, because a 15% market value drop directly signals a heightened probability of default by the issuing entity.
  3. C
    The portfolio is currently impacted by financial risk unique to government issuers, which can be fully eliminated by diversifying into long-term corporate bond issues.
  4. D
    The portfolio is currently impacted by call risk, which can be mitigated by holding Treasury bonds until maturity to guarantee protection against market value fluctuations.

Answer

The portfolio is currently impacted by interest rate risk (a systematic risk), whereas the investor's concern describes credit risk (a non-systematic risk that is virtually nonexistent for U.S. Treasury debt).
The correct option accurately distinguishes between systematic interest rate risk and non-systematic credit risk. The 15% drop in portfolio value is driven entirely by interest rate risk, which is a systematic risk affecting all fixed-income instruments when interest rates rise. In contrast, the investor's fear of default describes credit risk, which is a non-systematic risk specific to an issuer's inability to pay interest or principal. Because U.S. Treasury debt is backed by the full faith and credit of the U.S. government, its credit risk is considered negligible.

Step-by-Step Solution

1
Analyze the cause of the actual portfolio value decline.
The 15% market loss was caused by an increase in benchmark interest rates affecting long-duration fixed-income securities. This represents interest rate risk (a market-wide systematic risk).
Bond prices move inversely to interest rates; longer duration bonds exhibit greater price sensitivity to rate fluctuations.
2
Identify the nature of the risk feared by the investor.
The investor fears issuer default on coupon payments, which defines credit/default risk.
Credit risk is the possibility that an issuer fails to pay interest or principal when due.
3
Evaluate credit risk characteristics for U.S. Treasury securities.
U.S. Treasury debt is backed by the full faith, credit, and taxing power of the U.S. government and is considered virtually free of default/credit risk.
Credit risk is a non-systematic risk associated with specific issuer financial distress, whereas Treasury securities carry negligible credit risk.

Key Concept

Distinction Between Systematic (Interest Rate) Risk and Non-Systematic (Credit) Risk in Fixed-Income Debt
Estimated Time:1m 30s
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Topics

Non-Systematic and Credit Risks

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