NASAA Series 65, Uniform Investment Adviser Law ExaminationInvestment Vehicle CharacteristicsEasy
A portfolio manager is evaluating the risk profile of a client's debt holdings. They note that a significant portion of the bonds held are from corporate issuers with lower credit ratings. Which of the following risks is most prominent in this scenario?
- APurchasing Power Risk
- BInterest Rate Risk
- CLiquidity Risk
- DCredit Risk
Show answer & explanationAnswer & explanation
Correct answer: D. Credit Risk
Holding bonds from corporate issuers with lower credit ratings directly exposes the portfolio to higher credit risk, which is the risk that the issuer may default on interest or principal payments.
Why the other options are wrong
- A. Purchasing power risk (inflation risk) affects fixed-income investments generally, but is not specifically related to credit quality.
- B. Interest rate risk affects all bonds, but is not specifically tied to lower credit ratings.
- C. Liquidity risk is the risk of not being able to sell an investment quickly without a significant price concession, which can be a factor for lower-rated bonds but the primary risk from 'lower credit ratings' is default.
Credit Risk (Default Risk)
The risk that a bond issuer will be unable to make its promised interest payments or repay the principal amount at maturity.
- Higher for lower-rated bonds (e.g., 'junk bonds').
- Lower for higher-rated bonds (e.g., government bonds, investment-grade corporates).
- Can lead to partial or total loss of investment.
- Bond ratings (e.g., S&P, Moody's) assess credit risk.
Memory trick: Credit Risk: The company's credit is like its character – low rating means low trust.