Reading 62: Risks Associated with Investing in Bonds-LOS j 习 2011, statements, following, describe

1215

Session 15: Fixed Income: Basic Concepts
Reading 62: Risks Associated with Investing in Bonds

LOS j: Describe the various forms of credit risk and describe the meaning and role of credit ratings.

 

 

Which of the following statements is CORRECT?

A) When a rating agency downgrades a security, the bond's price usually falls.

B) Default risk is important because if a bond issuer defaults, the bondholder likely loses his entire investment.

C) Technical default usually refers to the issuer's failure to make interest or principal payments as scheduled in the indenture.

---

 

The market will likely demand a higher yield from the downgraded bond (the risk premium has increased) and thus the price will likely fall.

Technical default usually refers to an issuer’s violation of bond covenants, such as debt ratios, rather than the failure to pay interest or principal. In the event of default, the holder (lender) may recover some or all of the investment through legal action or negotiation. The percentage recovered is known as the recovery rate.

1215

When determining credit risk spread, the benchmark security is most likely a(n):

A) Treasury bond.

B) AA rated bond.

C) high-yield corporate bond.

---

The credit risk spread is measured in relation to a default-free security. Of the choices above, the security with the least chance of default is the Treasury bond. The AA rated bond is high quality, but not the highest quality (which would have an AAA rating). The high-yield corporate bond is an unlikely candidate for the benchmark security because high yield usually denotes high risk.

1215

With respect to bond investing, reinvestment risk is a very important component of what other type of risk?

A) Liquidity risk.

B) Default risk.

C) Call risk.

---

Call risk is composed of three components: the unpredictability of the cash flows, the compression of the bond’s price, and the high probability that when the bond is called the investor will be faced with less attractive investment opportunities. This latter risk is reinvestment risk. Reinvestment risk is not a directly related to any of the other choices.

1215

Which of the following will most likely have the least impact on a corporate bond rating? The:

A) issue's indenture provisions.

B) issuing company's volume of sales.

C) issuing company's debt burden.

---

The size of the issuing firm, represented by the amount of sales, will play a role in the financial stability of the firm. However, the other choices, leverage and indenture provisions, are more directly related to the bond’s rating. Smaller firms are not likely to issue bonds and issuers are typically larger firms overall.

1215

 

Suppose that a corporate bond and a government bond have equivalent characteristics. They both have a coupon rate of 6% paid annually and have two years remaining to maturity. Assuming a flat government term structure of 7% which of the following is a possible price of the corporate bond?

A) 98.19.

B) 97.76.

C) 101.35.

---

 

Since the corporate bond involves credit risk and the government bond doesn't. The corporate bond price has to be less than the government bond price which is computed as follows:

Government Bond Price = 6 / 1.07 + 106 / 1.07² = 98.19

1215

Benjamin Zoeller and Tara McGonigal are preparing for the Level I CFA examination. Zoeller is studying credit spread risk. McGonigal is farther along in her studies, but has forgotten how to determine the default free rate if given the yield on a bond rated BBB+ of 9.50% and a risk premium of 3.00%. What does Zoeller tell her to use for the default free rate?

A) 6.50%.

B) 9.50%.

C) 12.50%.

---

The formula for credit spread risk (or the yield on a risky asset) is:

Yield_Risky = Yield_RF + Risk Premium, where RF = default ? free rate.

Rearranging this formula results in: Yield_RF = Yield_Risky – Risk Premium, or Yield_RF = 9.50% – 3.00% = 6.50%.

1215

Credit risk is measured in several ways. The yield differential above the return on a benchmark security measures the:

A) default risk.

B) credit spread risk.

C) recovery rate.

---

The yield differential above the return on a benchmark security measures the credit spread risk. Credit spread risk is also known as the risk premium or spread.

1215

When planning to hold a coupon-paying Treasury bond until maturity, which of the following types of risk would be the most important?

A) Reinvestment.

B) Default.

C) Interest rate.

---

Since it is a Treasury bond, default risk is not relevant. Interest rate risk is not important because the investor plans to hold the bond until maturity. Reinvestment risk is the most important. The investor will have to worry about the rates at which he/she will be able to reinvest the coupons over the life of the bond and the principal upon maturity.