Level II Review, Fixed Income

Fundamentals of Credit Analysis

Posted by Joseph Hogue, CFA 

Study session 14 in the Level II CFA Program curriculum begins the material on fixed income with three readings (42-44) on valuation concepts. The material is not as recognizable for many candidates as the stuff on equity investments and can get tough at times. The first reading is fairly basic and secondary to the more practical information in the second reading. The topic is worth 10% of your Level 2 exam and you’ll need the concepts for Fixed Income in the next exam.

Fundamentals of Credit Analysis

The reading is like a 101 on credit analysis and good for your general knowledge of the industry. There are a few important concepts but they are all overall general concepts.
Understand the forms of credit risk: 

Spread risk is the loss of value from an increase in yield spread over other bonds due to the perceived increase in default risk of the issuer, notice it is from the perception of risk but not necessarily an actual downgrade

 Downgrade risk is the loss when an issuer is downgraded by an agency due to creditworthiness 

Market liquidity risk is the loss due to lack of sufficient participation to buy/sell the bonds in the quantity desired

Understand the difference between equity and credit analysis, and the four Cs of Credit

Capacity is the ability of the borrower to meet debt obligations

Collateral is the quality and value of the assets supporting the debt 

Covenants are the terms and conditions in a bond agreement

Character is the quality of management and willingness to satisfy debt obligations

The different ratios and ratio analysis in the reading are extremely important but reviewed in other sections. You can address them here or in the other sections, but you must know them. Know the difference between affirmative covenants (obligations the company must hold like paying interest, taxes and submitting audited statements) and negative covenants (limitations on the company like debt ratios and the amount of cash that can be paid out to equity holders).

Term Structure and Volatility of Interest Rates

Know the basis and implications behind the shapes of the yield curve (normal, flat, inverted, and humped). Understand the types of yield curve shifts (parallel and non-parallel) and what it means for relative value of bonds. The curriculum spends a lot of time explaining how to construct the theoretical spot rate curve for treasuries. Other than bootstrapping, it is still fairly conceptual so understand the basis behind each methodology (coupon strips, on-the-run treasuries, on-the-run plus select off-the-run, all treasury coupons and bills) as well as advantages or limitations.

Bootstrapping is a methodology that can be used to construct the spot curve when using securities with different maturities. The defined process is easily testable so put an example on a flashcard and drill it.

Example: 6-month U.S. Treasury bill has an annualized yield of 5% and the 1-year Treasury STRIP has an annualized yield of 4.5%. The yields are spot rates since these are discount securities. Assume that the 1.5 year Treasury is priced at $98 and its coupon rate is 5% ($2.5 every six months).
The 1.5-year spot rate is:
Price = $2.5/ (1+ (5%/2)) + $2.5/ (1/ 4.5%/2))2 + $102.5/(1+(18month spot /2))3
18-month spot rate = 6.464%

The four theories of the term structure of rates are also fairly testable but you really only need to know the basics.
1)      Pure expectations says that forward rates represent expected future spot rates and are not based on other systematic factors. It predicts that the expected spot rate in one year is equal to the implied 1-year forward, implying that expectations are unbiased and the shape of the yield curve depends on expectations.
2)      Liquidity preference states that long-term rates not only reflect expectations but also include a premium for investing in the long-term bonds, a liquidity premium. Rates are biased as holding long-term maturity requires the premium and that a yield curve may have any shape because the size of the liquidity premium is positively related to investor risk aversion.
3)      Preferred habitat states that rates are set by expectations  and a risk premium to compensate investors for buying bonds outside their “preferred” maturity.
4)      Market segmentation states that the slope of the curve depends on supply and demand conditions in the long and short-term markets. An upward-sloping curve indicates that there is less demand for short-term relative to long-term while a downward sloping curve would imply the opposite.
The quant material used to measure curve risk (rate duration, effective duration, and key rate duration) is extremely important and you will need it again in the third exam. Learn it now and save yourself the time next year.

Valuing Bonds with Embedded Options

The reading starts out fairly conceptual and easy with the interpretation of different spread measures. Understand the main differences between nominal, zero volatility, and option-adjusted spread.

The rest of the reading gets pretty intense with different methodologies for valuation of bonds with options. If nothing else, make sure you understand the concepts behind all the methods and the detail for constructing a binomial interest rate tree.
1)      Given the coupon rate and maturity, use the yield on the current 1-year on-the-run issue for today’s rate.
2)      Assume the level of rate volatility
3)      Given the coupon rate and market value of the 2-year on-the-run issue, select a value of the lower rate and compute the upper rate. R1,u= r1,l * e2volatility
R1,u is the upper rate (1 reflects the interest rate starting in year 1 and u reflects the higher of the two rates in year 1)
Volatility is the assumed volatility of the 1-period rate
e is the natural antilogarithm, 2.71828
4)      Compute the bond’s value one year from now using the interest rate tree
5)      If the value calculated using the model is greater than the market price, use the higher rate of r1,l and recomputed r1,u and then calculate the new value of the on-the-run issue using new rates. If the value is too low, decrease the interest rates in the tree.
6)      The five steps are repeated with a different value for the lower rate until the value estimated by the model is equal to the market price.

It’s a tough exercise to work through but often shows up on the exam so you need to get an understanding of it.  Study session 15 in the Level II CFA Program curriculum concludes the fixed income material with three readings on structured securities.

‘til next time, happy studyin’
Joseph Hogue, CFA

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