Level I Review: Fixed Income

Study Session 16 in the Level I CFA Program curriculum concludes the Fixed Income topic area with two readings, one on risk and return concepts and another on basic credit analysis. The credit analysis reading is completely conceptual and probably secondary to the first reading.
When I took the Level 1 exam, I was surprised by how conceptually-focused it was and how many of the formulas that I had studied for hours were not tested. They say the Level 1 exam is a mile wide and an inch deep because the curriculum touches a seemingly endless number of areas but does not go into much detail. For this reason, I always recommend to Level 1 candidates to focus on getting the main ideas and reasoning behind the concepts then to work on learning formulas.
This is especially true in SS16 with quite a few new formulas on duration and convexity. You will definitely need the basic duration and convexity formulas for the level 2 exam, so spend a little extra time here. You may or may not need to remember the formula for Macaulay duration, I would consider it of secondary importance to the others. Whatever you do, make sure you understand the concept of duration and convexity above all else.

Understanding Fixed Income Risk and Return

There are three sources of return for a bond; coupons, reinvestment and the return of face value. It is imperative that you understand how rising or falling rates affect the value of coupons and reinvestment opportunities.
If rates increase, the value of a bond decreases to make the yield competitive (i.e. since the coupons do not change, new investors/demand for the bond will require a market competitive yield so the price must change). If rates fall, the value of the bond increases but investors are exposed to reinvestment risk because of lower rates.
Understand how the time to maturity affects these concepts as well. The value of a long-term bond will rise and fall more with changes in interest rates because the change in reinvestment return has longer to affect the value.
This idea of rate risk on a bond’s price is known as Yield Duration (or just Duration). There are four measures: Macaulay, Modified, Effective, dollar and Price value of a basis point. The modified, effective, and dollar duration and PVBS are probably the most important to remember for the exam.
Modified Duration is the price of the bond at the lower rate minus the price of the bond at the higher rate (PVlow –Pvhigh) divided by two times the change in yield times the initial price (2*Yieldchg*PV0). It is a fairly easy formula to remember if you think about the concept first. You are measuring rate sensitivity so the numerator is the change in value with a change in rates. The denominator is the initial price times how much the rate change caused yield to change and multiplied by two. It may take a few practice problems but make a flash card and you’ll get it.
Effective Duration is basically the same formula but using the yield curve instead of the change in the bond’s yield. Understand that the Modified and Effective Duration will be different but will move closer together when: yield curve is flatter, maturity is shorter, price of bond is closer to par.
Understand the advantages and limitations to each method of measure for portfolio duration.
You will definitely need dollar duration for the second and third exam. Fortunately, once you have the basic duration formulas down then dollar duration is easy to remember.
The price value of a basis point is an estimate of the change in price when YTM changes one basis point. It’s a pretty quick and easy formula; the change in price with high and low rates (PVlow –Pvhigh) divided by two. Don’t forget that a basis point is one-hundreth of a percent (0.0001).
Convexity is also a very important concept in the reading. While duration only estimates the change in price from changes in rates, convexity measures the difference in that estimate on rate changes. Convexity will differ from duration the most when rates are much higher or much lower. Understand that callable bonds have negative convexity at lower rates because of the call option.

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 curriculum throws a ton of ratios at you to measure liquidity and financial strength but they are all discussed in more detail in other sections. Quickly understand how the ratio shows higher or lower credit risk but I wouldn’t spend too much time here. Study them in the equity and FRA topic areas where more detail is provided.
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).
Just a month and a half left to the exam. You should be well on your way to finishing your first pass through the curriculum and ready for a review of the more difficult/important topics. Start taking mock exams built off of question banks and end-of-chapter questions as well to start getting ready for the long 6-hour exam. These mock exams will help measure how you do when you have to sit down and test every topic area at once instead of individually.
‘til next time, happy studyin’
Joseph Hogue, CFA

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