Reading 61: Risks Associated with Investing in Bonds LOS 0:习 face, following, disaster, border

honeycfa

LOS o: Describe the various forms of event risk.

All of the following risks are types of event risk EXCEPT:

A) disaster/accident risk.

B) political risk.

C) interest rate risk.

---

Interest rate risk is the risk that interest rates will increase, decreasing the price of certain investments, including fixed-coupon bonds.

The other choices are examples of event risk, which refers to the possibility that there may be a single event or circumstance that could have a major effect on the ability of an issuer to repay a bond obligation.

 

honeycfa

Which of the following circumstances is an example of event risk?

A) The U.S. Federal Reserve unexpectedly increases interest rates by 100 basis points.

B) A local government regulatory agency introduces more stringent clean-water requirements that will significantly reduce the cash flow of an area paper mill.

C) A bond's bid/ask spread widens.

---

A local government regulatory agency introducing more stringent clean-water requirements that will significantly reduce the cash flow of an area paper mill is an example of regulatory risk, which is a type of event risk. The impact of regulatory risk can be long-term, in that the company may be unable to pass on the increased cost to customers.

The other choices are examples of other types of risk that bondholders face. A widening bid-ask spread indicates increased liquidity risk. The Federal Reserve’s action is an example of interest rate risk.

honeycfa

Kira Sigard, CFA and an attorney with an investment banking firm, structures a client’s bond issue to include a “poison put.” This is a provision that requires the issuer to redeem the bond at par in the case of a corporate takeover, a merger, or anti-takeover measure that would dissipate significant corporate assets. An investor who purchases this bond is protected from what type of risk?

A) Liquidity Risk.

B) Call Risk.

C) Event Risk.

---

Event risk refers to the possibility that there may be a single event or circumstance that could have a major effect on the ability of an issuer to repay a bond obligation. The poison put specifically protects an investor from corporate event risk.

Call Risk, or prepayment risk, is the risk that the issuer will repay principal prior to maturity. Prepayments are most likely to occur in a declining interest rate environment because it is cheaper to issue replacement debt. Liquidity risk addresses how quickly and easily an investor can sell a bond.

honeycfa

Which of the following is NOT an example of event risk?

A) Ratings agencies downgrade a company's rating after the company takes on a significant amount of debt to fund a leveraged buy-out (LBO).

B) A corporation calls a large bond issue.

C) An interim South American government imposes restrictions on the outflow of capital.

---

A corporation calling a large bond issue is an example of call risk.

The other choices are examples of types of event risk, which includes disaster/accident, corporate, regulatory, and political risks. Event risk refers to the possibility that there may be a single event or circumstance that could have a major effect on the ability of an issuer to repay a bond obligation. The South American government’s actions are an example of political event risk. The LBO-related rating downgrade is an example of corporate event risk.