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Difficulty: Very hardNon-Systematic and Credit Risks

A corporate treasury analyst is evaluating two fixed-income holdings in a firm's reserve portfolio: Security X, a 10-year U.S. Treasury note, and Security Y, a 10-year BBB-rated corporate bond issued by an industrial corporation. The Federal Reserve announces an unexpected 50 basis point increase in benchmark interest rates. Simultaneously, a major credit rating agency downgrades Security Y's credit rating to BB+ due to worsening leverage ratios at the issuing company. Which of the following statements correctly analyzes the primary risk factors driving the relative price changes of these two debt securities?

  1. A
    Both securities experience an increase in credit risk as a direct result of the Federal Reserve rate hike, which increases default probability across all sovereign and corporate debt issuers.
  2. B
    Security X is exposed to non-systematic interest rate risk that can be eliminated through portfolio diversification, whereas Security Y is exposed exclusively to systematic default risk.
  3. Security X is primarily subject to systematic interest rate risk, while Security Y is subject to both systematic interest rate risk and issuer-specific non-systematic credit risk resulting from its rating downgrade.Answer
  4. D
    Security Y's downgrade converts its price risk entirely into systematic market risk, while Security X is exposed strictly to non-systematic credit risk.

Answer

Security X is primarily subject to systematic interest rate risk, while Security Y is subject to both systematic interest rate risk and issuer-specific non-systematic credit risk resulting from its rating downgrade.
U.S. Treasury obligations (Security X) carry full backing by the U.S. government, making default risk negligible. Their price changes following a Federal Reserve interest rate increase are driven by systematic interest rate risk. In contrast, corporate debentures (Security Y) face interest rate risk alongside company-specific non-systematic risks such as credit/default risk. A rating downgrade from investment-grade (BBB) to speculative/junk status (BB+) reflects increased issuer credit risk, aggravating Security Y's price decline beyond the market-wide impact of the interest rate increase.

Step-by-Step Solution

1
Analyze the risk factors affecting Security X (U.S. Treasury note).
U.S. Treasury securities are backed by the full faith and credit of the U.S. government and are considered free of credit/default risk. However, their market prices fluctuate inversely with prevailing interest rates, exposing them to systematic (market) interest rate risk.
Systematic risks affect the overall market and cannot be eliminated through diversification.
2
Analyze the risk factors affecting Security Y (Corporate bond).
Corporate bonds are vulnerable to interest rate movements (systematic risk) as well as issuer-specific financial distress or rating downgrades (non-systematic credit risk).
Credit risk reflects the chance that an issuer will default or suffer a rating downgrade, which is specific to that corporate entity.
3
Synthesize the impact of the simultaneous macro event (rate hike) and micro event (credit downgrade).
The Fed rate hike depresses prices for both securities via systematic interest rate risk. The rating downgrade specifically worsens Security Y's credit spread, introducing additional price decline due to non-systematic credit risk.
Corporate bonds carry credit risk in addition to market interest rate risk.

Key Concept

Distinction between Systematic Risk (Interest Rate Risk) and Non-Systematic Risk (Credit/Default Risk)
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Topics

Non-Systematic and Credit Risks

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