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Difficulty: MediumNon-Systematic and Credit Risks

An investor purchases senior unsecured debt issued by a regional electric utility company. Shortly after the purchase, unexpected regulatory changes reduce the utility's approved rate structure, leading a credit rating agency to downgrade the company's debt from investment grade to junk status due to an increased likelihood of default. Which of the following risks has primarily increased for the investor, and how can an investor best mitigate this category of risk within a fixed-income portfolio?

  1. Credit risk, which can be effectively mitigated through portfolio diversification across different issuers and industry sectors.Answer
  2. B
    Interest rate risk, which can be eliminated by holding the utility bonds until their scheduled maturity date.
  3. C
    Systematic market risk, which can be eliminated entirely by spreading investments across several corporate bond issues.
  4. D
    Legislative risk, which can be mitigated only by substituting corporate debt with long-term US Treasury bonds.

Answer

The correct answer is credit risk, which can be effectively mitigated through portfolio diversification across different issuers and industry sectors.
Credit risk (or default risk) measures the risk that an issuer will fail to pay interest or principal in a timely manner. A credit rating downgrade due to declining financial health directly increases credit risk. Because credit risk is non-systematic (unique to the issuer), it can be effectively managed and reduced through asset diversification.

Step-by-Step Solution

1
Identify the primary risk event described in the scenario
The credit rating downgrade and increased likelihood of payment failure indicate a heightened possibility of default by the specific issuer.
Risk of financial default or inability to meet principal and interest obligations is defined as credit (or default) risk.
2
Classify the risk as systematic or non-systematic
Credit risk is a non-systematic (business/issuer-specific) risk rather than a market-wide systematic risk.
Non-systematic risks stem from factors unique to a single company or issuer.
3
Determine the appropriate risk mitigation strategy
Portfolio diversification across diverse issuers, sectors, and asset classes reduces exposure to single-issuer credit events.
Diversification spreads non-systematic risk, preventing a default in one security from severely impacting the entire portfolio.

Key Concept

Credit Risk and Non-Systematic Risk Mitigation
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Topics

Non-Systematic and Credit Risks

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