(21/01) MScFE 560 Financial Markets (C21-S1)

Collaborative Review Task M4

Case Study

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).

First statement
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.

Second statement
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:

• Interest rate risk Here, 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.