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Difficulty: Very hardNon-Systematic and Credit Risks

A financial advisor is evaluating an investor's fixed-income portfolio consisting exclusively of long-term AAA-rated municipal revenue bonds issued by a single municipal toll road authority. The investor believes that the high credit rating shields the portfolio from both market price fluctuations and issuer default. Which of the following statements accurately distinguishes the non-systematic risks of this portfolio from its systematic risks?

  1. The portfolio remains exposed to systematic interest rate risk regardless of credit quality, whereas the credit and business risks of the toll road authority are non-systematic and can be mitigated through diversification.Answer
  2. B
    Replacing the municipal revenue bonds with long-term U.S. Treasury bonds would eliminate credit risk as well as interest rate risk due to the sovereign backing of the U.S. government.
  3. C
    Because the bonds carry an AAA credit rating, the issuer's credit risk is eliminated, guaranteeing that the market value of the bonds will not decline during periods of rising interest rates.
  4. D
    Diversifying the portfolio across multiple municipal revenue bonds from different toll road operators will eliminate systematic market risk while leaving non-systematic credit risk unaffected.

Answer

The correct evaluation is that the portfolio remains exposed to systematic interest rate risk regardless of credit quality, whereas credit and business risks are non-systematic and can be mitigated through diversification.
The statement emphasizing that systematic interest rate risk persists regardless of credit rating, while non-systematic credit and business risks can be mitigated by diversifying, is accurate. Interest rate risk is systematic and inherent to all long-term fixed-income products. Credit risk and business risk are non-systematic, meaning they are specific to the toll road issuer and can be reduced by investing in securities across different issuers, sectors, and geographic regions.

Step-by-Step Solution

1
Categorize interest rate risk affecting long-term fixed-income securities.
Interest rate risk is a systematic (market-wide) risk that causes bond prices to fall when interest rates rise, regardless of issuer credit quality.
Systematic risks affect the broader market and cannot be eliminated through diversification.
2
Categorize credit and business risks specific to the toll road authority.
Credit (default) risk and business risk (traffic volume decline) are non-systematic (unsystematic) risks unique to this single issuer.
Non-systematic risks stem from specific entity operations or financial health and can be minimized by spreading capital across diverse issuers.
3
Evaluate the impact of credit ratings on investment risks.
An AAA rating indicates high creditworthiness but does not protect bond prices from interest rate fluctuations.
Credit ratings measure default probability, not market price sensitivity to changing interest rates.

Key Concept

Non-systematic risk vs. Systematic risk and the role of diversification in fixed-income portfolios
Estimated Time:1m 40s
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Topics

Non-Systematic and Credit Risks

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