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Difficulty: HardNon-Systematic and Credit Risks

An investor holds revenue bonds issued by a local transport authority to fund a municipal toll bridge. Two years after issuance, an adjacent state highway opens without tolls, causing traffic volume and bridge revenue to fall dramatically below projections. The investor becomes concerned that the issuer may fail to make scheduled coupon payments. Which type of risk does this investor primarily face, and what is the primary strategy to mitigate this risk across a fixed-income portfolio?

  1. Credit risk, which can be mitigated by diversifying investments across multiple distinct issuers and industry sectors.Answer
  2. B
    Interest rate risk, which can be eliminated by holding the revenue bonds until their final maturity date.
  3. C
    Systematic risk, which can be mitigated by purchasing municipal revenue bonds with varying maturity dates from the same local issuer.
  4. D
    Market risk, which can be mitigated by reinvesting all semi-annual coupon payments into US Treasury securities of equal duration.

Answer

Credit risk, which can be mitigated by diversifying investments across multiple distinct issuers and industry sectors.
The risk described involves a specific revenue project's inability to generate expected revenue to pay bondholders, which directly defines credit (default) risk. Credit risk is a form of non-systematic risk specific to the issuer, and it can be effectively reduced by spreading investment capital across different issuers and sectors.

Step-by-Step Solution

1
Analyze the cause of risk in the scenario.
The risk stems from a specific operational event (a competing free highway reducing toll bridge revenues), which impairs the issuer's financial ability to service its debt.
Risk tied to a specific issuer's operational performance or financial health is non-systematic credit risk.
2
Distinguish between systematic and non-systematic risk.
Systematic risk affects the overall market (e.g., inflation, interest rates), whereas non-systematic risk is company- or project-specific.
Issuer default and credit downgrades are classic examples of non-systematic risk.
3
Identify the primary portfolio management strategy for non-systematic risk.
Diversification across different security types, issuers, and sectors reduces exposure to any single issuer's financial distress.
Because non-systematic risks are uncorrelated across distinct issuers, proper asset allocation minimizes their impact on an overall portfolio.

Key Concept

Credit Risk and Non-Systematic Risk Mitigation
Estimated Time:2m 0s
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Topics

Non-Systematic and Credit Risks

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