Credit Risk

A corporate treasurer must park 2 million dollars of operating cash for about four months in the safest instrument available with a matching maturity. The most appropriate Treasury security is a...

1. A.Treasury noteNotes start at 2 years. Selling one after four months exposes the cash to interest-rate risk that the bill avoids.
2. B.Treasury billCorrect. Bills are issued in maturities of one year or less, so a 13-week or 17-week bill matches the horizon.
3. C.Treasury STRIP maturing in 10 yearsA long zero-coupon instrument has the highest duration of all, making it the most price-volatile choice for short-term cash.
4. D.Treasury bondA 20- to 30-year maturity is grossly mismatched to a four-month need, even though the credit quality is identical.

Why: Treasury bills are auctioned in maturities of one year or less, including 4-week, 8-week, 13-week, 17-week, 26-week, and 52-week terms. A 13-week or 17-week bill matches the four-month horizon with essentially no credit risk and minimal price risk.

U.S. Treasury securities are generally regarded as carrying the lowest level of which risk?

1. A.Credit, or default, riskCorrect. Full faith and credit backing makes Treasury default risk the benchmark low in the market.
2. B.Purchasing-power riskFixed Treasury coupons are quite vulnerable to inflation, which is precisely why TIPS were created.
3. C.Reinvestment riskTreasury coupons must be reinvested at whatever rate prevails, so this risk is present just as it is with other coupon bonds.
4. D.Interest-rate riskTreasuries are highly exposed to interest-rate risk. A 30-year Treasury can lose substantial market value when rates rise.

Why: Treasuries are direct obligations backed by the full faith and credit of the U.S. government, which can tax and issue currency, so their default or credit risk is considered the lowest available in the market.

An investor holds bonds from thirty unrelated issuers across many industries, and inflation then accelerates across the whole economy. How is the resulting erosion of her real return classified?

1. A.Nonsystematic, because each issuer's ability to pay is affected to a different degree.Wrong. What is eroding is the real value of the payments, which is independent of any issuer's finances.
2. B.Nonsystematic, because further diversification across issuers would reduce the exposure.Wrong. More issuers simply means more streams of fixed payments, every one of them eroded by the same inflation.
3. C.Systematic, because a general rise in prices erodes every fixed payment at once.Correct. Purchasing power risk arises from an economy-wide condition and reaches every fixed-income holding together.
4. D.Systematic, but only for issuers whose costs rise faster than their revenues do.Wrong. That describes business risk at particular firms, a separate exposure that diversification does address.

Why: Systematic risks are driven by conditions affecting the whole market or economy, which is why they cannot be diversified away. Inflation is exactly such a condition, reducing what every fixed payment buys whoever the issuer happens to be. Spreading across thirty issuers protects against one of them defaulting, a nonsystematic exposure, and does nothing about the general price level. An investor who wants to address this has to change the type of instrument, moving toward inflation-adjusted or floating-rate securities.

A client owns a callable corporate bond purchased at a premium. Rates fall and the issuer calls the bond. Which statement best describes what has happened to her?

1. A.The issuer defaulted on its obligation, so the client has suffered credit risk.Wrong. Exercising a contractual right is the opposite of a default, and the issuer paid exactly what it promised.
2. B.The client loses an above-market coupon and must reinvest at lower rates.Correct. Issuers call when they can refinance more cheaply, which is exactly when the holder least wants the cash back.
3. C.The client benefits, because a call is exercised only when a bond is worth less.Wrong. The call comes when the bond has become valuable to the holder, which is why the issuer wants it retired.
4. D.The client is unaffected, because the call price was disclosed at issuance.Wrong. Disclosure at issuance explains why the call was permitted, not why the holder is worse off for it.

Why: A call provision lets the issuer retire the bond early, and issuers exercise it when rates have fallen far enough to refinance at a lower coupon. From the holder's side the timing is uniformly unfavorable: the attractive above-market coupon disappears and the proceeds can be reinvested only at the new lower rates. The exposure is closely related to reinvestment risk and is driven by market-wide rate moves rather than by anything peculiar to the issuer. A holder who wants to avoid it should seek call protection or buy non-callable issues.