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Difficulty: MediumNon-Systematic and Credit Risks

An investor holds a portfolio consisting of high-yield corporate bonds issued by a single biotechnology firm facing upcoming regulatory approval hurdles, along with long-term zero-coupon U.S. Treasury bonds. Which of the following statements regarding the non-systematic and credit risks of these securities are correct?

  1. The corporate bonds carry business risk and credit risk that can be significantly reduced through asset diversification across different issuers and industries.Answer
  2. The long-term U.S. Treasury zero-coupon bonds carry negligible credit risk, yet remain subject to significant interest rate risk.Answer
  3. C
    Spreading the portfolio across bonds of ten different biotechnology companies will completely eliminate overall market risk.
  4. D
    The primary risk impacting the long-term U.S. Treasury zero-coupon bonds is credit risk driven by potential corporate financial distress.

Answer

The correct statements are that the corporate bonds carry business and credit risks that can be mitigated through asset diversification, and that long-term U.S. Treasury zero-coupon bonds carry minimal credit risk while remaining exposed to interest rate risk.
Non-systematic risks such as business risk and credit (default) risk are specific to individual corporate issuers, like a biotech firm, and can be mitigated through asset diversification across multiple sectors. In contrast, U.S. Treasury obligations are backed by the U.S. government and carry minimal credit risk; however, long-duration zero-coupon Treasuries are heavily exposed to interest rate risk, which is a systematic risk.

Step-by-Step Solution

1
Analyze the high-yield corporate bond position for non-systematic risk factors.
Identified that corporate bonds are exposed to issuer-specific business operations and financial default (credit risk), which can be diversified away.
Non-systematic risks are unique to an individual issuer and can be mitigated by holding a diversified portfolio.
2
Evaluate the risk profile of long-term U.S. Treasury zero-coupon bonds.
Identified that sovereign debt virtually eliminates credit risk, but zero-coupon long-term bonds carry high interest rate (systematic) risk.
Treasuries carry the highest credit rating backed by the U.S. government, but longer maturity fixed-income instruments fluctuate significantly when interest rates change.
3
Distinguish between non-systematic risk diversification and systematic market risk.
Confirmed that diversifying within or across issuers reduces non-systematic risk, but market-wide systematic risk remains.
Systematic risk affects the broader market and cannot be eliminated through asset diversification.

Key Concept

Non-Systematic Risk vs. Credit Risk and Diversification
Estimated Time:1m 30s
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Topics

Non-Systematic and Credit Risks

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