Level III Review Fixed Income

Study session nine in the Level III CFA Program curriculum includes two readings (23-24) in management of passive and active fixed-income portfolios. There is a lot of information here and almost all is highly testable. The entire topic is worth between 10% and 20% of your exam so be prepared to spend enough time to get the material.
Fixed-Income Portfolio Management
Understand the concepts and advantages/disadvantages between the bond indexing strategies. As with the equity index techniques, the methods fall along a continuum of fees (lower for passive to high for active management), tracking risk (almost none for passive to high for active), and expected return (higher for active management).
Pure indexing– Very low tracking error with low advisory and admin fees but can be costly and difficult to implement. Will underperform the index. Active management– Highest expected return and fewest restrictions but highest risk, tracking error and fees.
Understand the basic types of risk: market value (varies directly with maturity because longer duration instruments lose their value most with a change in rates), income risk (varies indirectly with maturity because the income stream will be less known if investments must be constantly rolled over), credit risk, liability framework risk.
Understand the process and differences between stratified sampling and scenario analysis. Stratified sampling is a method of matching to the index by separating the universe of bonds into cells that correspond to a risk factor like quality, duration, sector, etc. By selecting bonds from each cell, the manager can replicate the index without buying every bond.
In scenario analysis, the manager runs simulations given different rate changes and spreads to analyze affect on the portfolio. By running a continuous program, the manager can build a better idea of the expected return and volatility over many scenarios.
Understand the extensions to classical immunization:
Key rate duration – certain key rate maturities are targeted
Multiple liability immunization – portfolio contains sufficient liquid assets to meet liabilities as they mature
Contingent immunization – combination of active strategies and immunization. As long as the rate of return on the portfolio is higher than the safety net return, the portfolio is actively managed.
Understand the difference between a bullet strategy (maturities centered around one liability date) and a barbell strategy (where maturities are scheduled several years before or after the liability date).
Cash flow matching is a portfolio strategy to fund a liability stream with coupons and bond maturities.
Be able to do all the calculations behind dollar duration and rebalancing.
Relative-Value Methodologies for Global Credit
The concepts behind top-down and bottom-up are the same as in the equity material. Top-down focuses on the macroeconomic forces and industrial factors while bottom-up targets individual issuers with value relative to peers.
Understand the basic concepts behind the nine relative value methodologies:

  • Total return focuses on analysis of past returns and risk-adjusted future returns
  • Primary market is based on supply/demand of new issues with increasing supply resulting in spread contraction and higher relative returns
  • Liquidity and trading focus on specific needs with a trade-off between return and liquidity
  • Secondary trading rationales and constraints including: yield/spread pickup, credit upside, structure trades, credit-defense, cash flow reinvestment, new issue swaps, curve adjustment trades, and sector-rotation trades. The four main trading constraints are portfolio constraints, story disagreement, buy-and-hold, and seasonality.
  • Spread includes nominal, static or zero-volatility, OAS, credit-swaps, and credit default spreads
  • Structure analysis involves choosing different structures like bullet, callable, putable, and sinking-fund to enhance risk-adjusted returns
  • Credit curve – spreads tend to widen with increased rate volatility and as maturity lengthens as well as with credit risk
  • Credit analysis is used to identify credit upgrade or downgrade candidates and involves studying the issuers financial statements, interviews with management, and understanding the industry
  • Asset allocation/sector identifies sectors/firms that are expected to outperform

Study session 10 concludes the material on fixed-income with two more readings. The material on fixed income securities is often harder for candidates because they do not have as much exposure to the asset. Don’t be too hard on yourself if you have trouble getting the material. Make sure you are doing the practice problems at the end of the chapters and the blue-box examples. If you are unsure of your progress, take a couple of practice exams in the section (a few days or a week apart) to make sure you have committed the material to memory. Aim for at least 75% correct and don’t forget to actively review the questions you missed.
‘til next time, happy studyin’
Joseph Hogue, CFA


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