Level I | Fixed Income and an Important Message

Before we begin our review of the Fixed Income topic area for the December exam, there is an important message you need to consider. As if the need to pass the exam in December were not pressing enough, it may be even more so because of curriculum changes.
The idea occurred to me while looking through the Fixed Income material for this week’s review. The December exam is still based on the 2014 curriculum. If you do not pass the exam in December, you will need to change to the 2015 curriculum. While it is not completely different, there are three new readings and six dropped readings. Along with some changes to topic weightings, this makes for a lot of additional or wasted studying if you have to retake the exam. Check out all the changes to the 2015 Level I CFA Program Curriculum in our prior post.
Now, on to the review of Fixed Income with Study Session 15. This is the first of two study sessions and includes five readings. The topic area is worth 12% of your total exam score but this basic material will be very important to your ability to understand details in the next two exams. Most candidates, myself included when I was one, have not been exposed to concepts in Fixed Income as much as we have to Equity. Some of the specifics and pricing can be pretty difficult so make sure you get these basics down now.

Fixed Income Securities: Defining Elements

Almost entirely conceptual and should be easy to pick up if you make a few flash cards for the vocabulary and broad concepts.
Sovereign bonds: Government issued and relatively lower risk. They can be issued in local or foreign currencies. Understand the basic differences of the U.S. debt like T-notes, T-bonds, Strips and TIPS.
Quasi-government: These are issued by a non-government agency but often carry an implicit guarantee as being connected to the government. The focus is on agency mortgage debt and the types of CMO and MBS, think Fannie Mae and Freddie Mac a few years ago.
Municipal or province: Like sovereign bonds but issued by smaller authorities like towns and cities. Understand the difference between tax-backed and revenue bonds and the effect on risk. The interest is often tax-advantaged for taxes owed to the issuing municipality or state.
Corporate Bonds: Understand the four factors used by credit rating agencies (character, capacity, collateral, and covenants). This section has a few formulas and is probably one of the more testable in the reading.
Mortgage backed securities: Understanding structure and prepayment risk is the important material here and will be used for more detail in the Level 2 exam.
Asset backed securities: Understand the types of internal and external credit enhancements as well as the role of special purpose vehicles.
Collateralized debt obligations: These are basically the same as asset-backed debt but the backing for the bond is a diversified pool of different debts, i.e. domestic/foreign bonds, bank loans, distressed debt, ABS, and MBS
Understand the difference between current yield (coupon interest / bond price) and yield to maturity. The YTM is the annualized rate which makes the present value of cash flows equal to current market price, effectively the yield an investor will earn if held to maturity. The YTM will not change once the bond is bought. The current yield is just a matter of where the bond trades now but can change.
Understand the basic types of affirmative and negative covenants like paying interest & taxes, meeting financial ratios, limitations on additional debt, and restrictions on asset sales. Affirmative covenants are things an issuer MUST do while negative covenants are things they must NOT do to avoid a default.
Definitions and just knowing the lingo is always important. Know what a coupon is and understand what happens to the price if the coupon rate is higher or lower than current market rates. Think about it intuitively. If a bond offers a higher coupon rate than you can find in the market, you are going to be willing to pay a premium on the price, and the opposite is true for a coupon rate below the current market yield.
Understand the basic idea behind call and put provisions, sinking funds, repurchase agreements and prepayment. Remember, the full or dirty price is the agreed price plus all accrued interest.
I always thought credit enhancements were an interesting part of the material. Internal enhancements are collateral or other features promised by the issuing company to further back the bonds. External enhancements are guarantees promised by a third-party to back the bonds. They are a way of boosting credit worthiness of the bonds and lowering the interest rate, and some are pretty creative structures.

Fixed Income Securities: Issuance, Trading and Funding

There seems to be a lot of overlap in this reading with the first. Again, almost entirely conceptual and you really just need to get the vocabulary. As always pay attention anytime the curriculum compares two options, gives advantages or limitations and provides any list detail.
The material on sovereign bonds is relatively important. Understand the difference between local currency bonds and foreign currency bonds, especially their advantages and limitations. Local currency bonds may have less demand but the government has more control of its currency to repay debt. Foreign-denominated bonds may offer lower rates (higher demand) but can present problems if the local currency depreciates against the foreign currency.
Understand the different types of corporate debt, i.e. bank & syndicated loans, commercial paper, and corporate notes. Pay attention to the different structures, term issued, and provisions in each.

Introduction to Fixed Income Valuation

This is likely the most important reading of the study session, especially when it comes to being ready for the next study session and the next two exams.
You really need to understand the concepts behind bond valuation and calculating yields. I am including a few examples of how to use your BA II Plus calculator for this work to help you do problems quickly on the test but do not completely rely on your calculator. Learn the concepts.
(Remember to always press – 2nd and then CLR TVM – to clear out prior work. It’s an easy habit to get into before each calculation and it might save you a couple of errors on the exam.)
Find the price of a 10-year fixed rate bond with a $1,000 face value and a semi-annual coupon if the yield is 6%
N = 20 (don’t forget that it is semi-annual)
I/Y = 3 (6% yield divided by twice a year)
PMT = 20 (4% coupon times face value divided by twice a year)
FV = 1000 (you receive the face value at expiration)
CPT PV = $851.23
You can use the TVM keys to find any of these (years to maturity, coupon rate, yield) as well.
Understand the idea behind discount, par and premium and how it relates to the coupon rate and market rates. If the coupon rate is above market rates then the bond will be attractive, price will be higher than par and will trade at a premium.
You absolutely must understand the basic idea behind convexity. The percentage change in a bond’s price will be different at different changes in the discount rate. This material will become even more important on the other two exams.
Pay special attention to the material on yield spreads as well. The spread is just the difference between the bond’s yield and a benchmark (usually a government issued security of the same term). Option-adjusted spread is the spread with an embedded option and represents the risk remaining after rate and volatility risk have been removed. You will see all these terms in much greater detail on the Level 2 exam.
Study Session 16 concludes the Fixed Income material with two readings on valuation of risk. One reading is mostly conceptual while the other is likely the most important and testable of the topic. We’ll cover it in detail next week. Until then, let me know if you have any questions.
‘til next time, happy studyin’
Joseph Hogue, CFA

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