An investor holds a fixed-income portfolio heavily concentrated in corporate bonds issued by a single retail company. The investor is concerned that poor financial performance by the issuer could lead to a credit rating downgrade or default on interest payments. Which of the following best identifies the primary risk described and the most effective strategy to reduce it?
- Credit and business risk, which can be effectively reduced by diversifying investments across multiple issuers and industry sectors.Answer
- BInterest rate risk, which can be eliminated by holding the corporate bonds until their scheduled maturity dates.
- CSystematic market risk, which can be completely eliminated by spreading bond purchases across different maturity dates.
- DCapital risk, which can be avoided by exchanging the corporate debt for preferred stock of the same issuing firm.
Answer
Credit and business risk, which can be effectively reduced by diversifying investments across multiple issuers and industry sectors.
Business risk and credit (default) risk are non-systematic, issuer-specific risks. Because these risks depend on the financial stability of a single entity, investors can significantly mitigate them by diversifying their holdings across multiple issuers and sectors.
Step-by-Step Solution
Key Concept
Non-systematic risk (credit/business risk) is issuer-specific and can be mitigated through portfolio diversification.