2.3.2. Types of Nonsystematic Risk
Business. Risks associated with the characteristics of a particular issuer constitute business risk. Business risk includes the risk of competition, poor management, or products/services becoming obsolete. Businesses in different sectors of the economy face different forms of business risk. Airlines, retailers, and financial services companies, for example, would all face different business risks. Sometimes sources of business risk affecting companies in a particular sector are referred to as sector risk. Diversifying a portfolio across sectors may reduce the overall impact of business risk and sector risk.
Credit. Credit risk is the risk of an actual or perceived decline in an issuer’s creditworthiness. One type of credit risk is default risk, which is the risk that a borrower or bond issuer will fail to make payments when due. The possible consequences of a default to an investor range from a minor hit to income stemming from a missed payment to the loss of the investor’s entire principal. Credit risk is generally lowest on bonds issued by national governments—the risk of default on such bonds is called sovereign risk—and highest on corporate bonds, especially junk bonds.
Credit ratings by bond rating services attempt to categorize the perceived credit risk attached to bonds from different issuers. Bond investors compensate for credit risk by demanding that riskier bonds offer higher yields; investment grade bonds have lower risk and correspondingly lower yields. An investor can minimize credit risk by avoiding higher risk bonds altogether. This rating system creates its own form of credit risk. Credit deterioration risk is the risk of a credit rating downgrade. This is a risk for the investor because it may make it more difficult to sell the investment and/or it may drive down the market price.
Reinvestment. Reinvestment risk is the risk that the investor will get his capital back early. Recalling the old sayin