A credit rating agency downgrades a private university's revenue bonds from A to BBB following a sustained decline in student enrollment and tuition revenue. Which type of risk is directly illustrated by this rating downgrade, and how can a fixed-income investor best mitigate this specific risk?
- Credit risk, which can be mitigated by diversifying the bond portfolio across multiple issuers and sectors.Answer
- BInterest rate risk, which can be mitigated by holding the bonds until their stated maturity date.
- CSystematic market risk, which can be eliminated entirely by diversifying holdings across different fixed-income sectors.
- DCall risk, which can be mitigated by selecting revenue bonds with longer call protection periods.
Answer
Credit risk, which can be mitigated by diversifying the bond portfolio across multiple issuers and sectors.
The rating downgrade reflects deteriorating financial conditions of the specific bond issuer, which directly represents credit risk (default risk). Because credit risk is non-systematic (unique to individual issuers), investors can mitigate it by diversifying their portfolio across different issuers and bond types.
Step-by-Step Solution
Key Concept
Credit risk is a non-systematic risk associated with an issuer's financial stability and ability to meet debt obligations. Because it is unique to specific issuers, it can be significantly reduced through portfolio diversification.