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Difficulty: MediumNon-Systematic and Credit Risks

An analyst is evaluating the risk profile of an investor's portfolio that is heavily concentrated in corporate bonds issued by a single retail department store chain. Which of the following statements correctly describe the non-systematic and credit risks associated with this holding?

  1. Diversifying the portfolio across issuers in multiple distinct industries can significantly reduce the investor's exposure to this specific default risk.Answer
  2. A credit rating downgrade of the retail chain by a major rating agency represents a non-systematic event that typically depresses the market price of its bonds.Answer
  3. C
    A broad increase in prevailing market interest rates directly reflects an increase in the retail chain's specific credit risk.
  4. D
    Spreading funds among several different retail corporate issuers completely eliminates the portfolio's exposure to overall purchasing power risk.

Answer

Diversifying across multiple issuers and sectors reduces issuer-specific default risk, and a credit rating downgrade is a non-systematic event that depresses bond market value.
The correct statements correctly identify that non-systematic risk can be mitigated through asset diversification across issuers and sectors, and that credit rating downgrades are company-specific events that adversely affect bond pricing.

Step-by-Step Solution

1
Identify the nature of non-systematic and credit risks.
Non-systematic risk (including credit, business, and operational risk) is unique to a specific company or industry, whereas systematic risk affects the whole market.
Credit risk specifically concerns an issuer's ability to make timely interest and principal payments.
2
Evaluate the effect of portfolio diversification on non-systematic risk.
Adding bonds from different issuers across varied industries dilutes the impact of any single issuer defaulting.
Diversification is the primary method for reducing non-systematic risk.
3
Analyze how rating agency actions affect bond market prices.
A rating downgrade signals heightened credit risk, causing secondary market prices for the issuer's debt to fall.
Investors require higher yields to compensate for elevated credit risk.
4
Distinguish non-systematic credit risk from systematic market risks.
Broad interest rate shifts and inflation are systematic risks affecting all fixed-income securities and cannot be eliminated by corporate bond diversification.
Systematic risks stem from macro-economic factors rather than individual corporate financial health.

Key Concept

Non-Systematic Risk vs. Systematic Risk and Credit Risk Mitigation
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Topics

Non-Systematic and Credit Risks

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