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Suppose that a capital-markets investment fund wants to lower the amount of risk they are
exposed to. They call a meeting to discuss whether they hold a suitable balance between
equity and bond investments. One person thinks they should decrease their bond
investments, mentioning that “a high debt-to-equity ratio is very risky”. Someone else
disagrees, suggesting that they decrease their equity investments because “bond
investments provide fixed cash flows and are therefore free of risk”.
Explain why the first statement is correctly understood and applied but is mistaken in this
context. Then explain why the second person’s opinion is valid, even though their statement
is not quite correct (making sure to explain why it is not correct).

Although high debt-to-equity ratio is considered risky, its level of perceived riskiness differs

from one context and industry to another. Generally, ‘high debt-to-equity ratio is very risky’, and

is associated with high risk debtors. It indicates a company that has been aggressively financing

its capital, hence, greater ability to leverage on its resources in deriving growth and

sustainability. The first statement seeks to contextualize debt-to-equity ratio in a company’s

capital structure. However, the argument confuses between bonds and equities in the context of

company financial structure. In particular cases, high debt-to-equity ratio may be suitable,

especially, when most of the debt is long-term. In such a case, short-term debt financing through

bonds would be suitable. Thus, decreasing bond investments does not always lower the debt-to-

equity ratio and risk exposure borne by the company.

The second person’s opinion is that the company should decrease its equity investments because

‘bond investments provide fixed cash flows and are therefore often free of risk’. The context of

this argument is that bonds are part of company debt structure, and further that investing in

bonds attracts negligible amount of risk. The impact of decreasing bonds held by the company

lowers its overall debt, hence, increases its debt-to-equity ratio, signifying higher amount of

leverage. However, the statement is not quite correct because bonds are not entirely risk-free, but

they carry with them a considerable amount of risk. The risks borne by bonds include:
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 Interest rate risk, where interest rates have inverse relationship with bond prices.

Therefore, buying a bond is committing to a fixed rate of return held against variable and

fluctuating interest rates.

 Reinvestment risk, where the proceeds from future bond cash flows are at times

reinvested at a lower yield than originally provided for in the original bond prices.

 Default risk. Like other investments, holding bonds carries with it a considerable risk of

default.

 Inflation risk, where general prices of commodities increase. This is particularly

disadvantageous to companies holding bonds whose redemption values are inflation-

linked.