Your Cheat Sheet to… CFA Level I: Fixed Income

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By Tapo

The Cheat Sheet articles are a series of articles, each focusing on one specific topic area of the CFA exam for one specific CFA level. In each Cheat Sheet article, we will cover the basics of what you need to know before diving into the material – what it’s about in a nutshell, how significant is it in the CFA exams, real-life applications, and tips for the CFA exams. You should aim to read each relevant Cheat Sheet article before you start studying the topic area to get you to a flying start.

For this article, we will look at Fixed Income Investments for CFA Level I, one of the more quant intensive topics in CFA Level I and something that should build a base for the subsequent levels as well.

What is the weighting of Fixed Income Investments in the CFA exam?

​The Fixed Income Investments section constitutes around 10% of the total CFA curriculum. This means you can can expect roughly 24 questions in the exam that are related directly to this topic.

What is the Fixed Income Investments topic area about, in a nutshell?

The Fixed Income Investments topic area constitutes one of the largest segments of the broader capital market. It mostly covers any investments where investors are loaning the money for a fixed, scheduled repayment: hence the name ‘fixed income’.

Fixed income investments includes bonds, debenture, government debt and mortgage backed securities (yes those very financial products that gained infamy in the aftermath of the 2008 crisis!), to name a few. It also includes certain derivatives that have other underlying Fixed Income securities. These type of securities are directly affected by and are therefore very sensitive to interest rates.

The subtopics of Fixed Income Investments are summarized below:

​Fixed-Income Securities: Defining Elements
Fixed-Income Markets: Issuance, Trading, and Funding
Understanding what a fixed income security is, and what’s its basic structure like.
Understanding the structure and norms of the fixed income market.
Introduction to Fixed-Income Valuation 
Introduction to Asset-Backed Securities
Highlights the nuances of valuing and pricing fixed income securities.
Dives into the detail of asset-backed securities and sub-products, such as residential and commercial mortgage-backed securities.
Understanding Fixed-Income Risk and Return 
Fundamentals of Credit Analysis 
Outlines the types of risks associated with typical fixed income securities.
Focuses on credit risk, a type of risk especially relevant to fixed income.

As a fixed income investment can be a lengthy schedule of multiple fixed or variable repayments, valuing and pricing fixed income investments can be quite tricky. Before you start reading this section, it’s a good idea to have familiarity with Time Value of Money and the Discounted Cash Flow approach. These concepts are covered by the first two subtopics of the Quantitative Methods topic area.

Why should I care about Fixed Income Investments in real life?

Everyone, including you, is or will be involved in a fixed income security at some point in their lives. Student loans, savings accounts, mortgages, and even loan-shark debts are fixed income securities, in which we may be the borrower or issuer (i.e. the lender).

This CFA topic area aims to introduce readers to the basic concepts of Fixed Income securities available in the market and how they are priced and valued. The topics help put together a foundation on which candidates can then build upon in the future. The concepts discussed are especially important for those who aspire to be in Fixed Income Portfolio Management – credit, macro or otherwise.

Even for those who do not plan to pursue a career in Fixed Income, these topics will be an inalienable part of their skill repertoire. This is because the various markets are often related and great investors (e.g. Warren Buffet, Peter Lynch, George Soros) often possess knowledge of different kinds of markets – not just the market they are investing in.

I believe there are two key takeaways from this section for aspiring investors:

  1. The various Fixed Income Products available in the market and how these markets operate
  2. How to price these securities: What are the risk factors to pricing a Fixed Income security and how to hedge any associated risks? (Trust me – these concepts come in very handy when you have to value a bond in half a minute or less!)

Tips for the exam you should know

Should I start my studies with Fixed Income Investments?

If you are quantitatively inclined, I suggest you do look at this early in your CFA studies. You will find this section very interesting and probably a bit of a reprieve after some of the more demanding sections. But of course, familiarize yourself with the concepts of Time Value of Money and the Discounted Cash flow approach first if you are new to finance. This is probably one of those sections where the answers are less ambiguous and not much needed to be committed to memory. So if you have trouble remembering stuff (like I have) I would strongly suggest you use this section to maximize your score. It should help you build up the tempo for other more serious topics and at the same time you get cover roughly 10% of the syllabus.

It is important to develop that understanding of fixed income products and how to leverage the concept of zero arbitrage valuation in pricing these securities. If you are new to the world of finance, these can take some time. But once you do achieve some level of understanding, these concepts will serve you very well in other topics as well. In all, this topic can earn you a lot of points in the exam if you put in just enough effort.

This doesn’t mean that you cannot explore this section later on. This is one section that gives you the flexibility to choose when and how you want to approach this section. But in my experience, sometimes spending too much time on some of the other more intensive sections can leave you with very little time to spend on this topic. This is neither advisable nor desirable – especially since this section can yield you a lot of returns for a limited investment.

What materials should I use?

This depends wholly on where you currently stand. If you come with a background in Fixed Income, it will be like a fish taking to water. If you are new to finance, certain concepts can be very alien. I would recommend using prep provider notes – you can see what’s on offer here. If you find some of the concepts hard to get, move up a notch and consult the CFA Institute curriculum, which is useful for occasional deep-dives but may be too dry and lengthy to function well as your main study material. If you’d like more reading material, I recommend getting Frank J Fabozzi’s Handbook of Fixed Income Securities

An important calculator tip

If you want to ace this section (and you do), your CFA calculator is your best friend. Fixed Income Investments is a topic area that is especially calculator-heavy, and CFA exam calculations are not your regular multiplications and divisions that you can do using a paper and a pen. So you’ll need to know your calculator’s functions and operations like the back of your hand. Practice regularly with practice exams and given examples, and consider having a look at some calculator guides. We’ve got a few here:

I am a Fixed Income savant. Should I still go through this section?

Yes, even if you think you’re really awesome. Just in case. Fixed Income is one of the largest segments of the broader capital market. So even if you are a in Fixed Income specialist, chances are you are specialized in one or two of the CFA topics, but not all of them. The Level I syllabus is broad-based and aims to cover much of the Fixed Income landscape. So it is always safer to give it a read.

What do I do to practice?

As the saying goes – practice makes perfect. It is not different with this topic. If you are new to finance and Fixed Income, make sure you go through enough numerical problems before you sit for the actual exam from study notes. Then try and attempt the questions that you may find in the CFAI official books. Finally, attempt your practice exams, and that should form a pretty solid preparation.

How does Fixed Income get tested?

Let’s run through a few examples to see how Fixed Income is tested in the CFA exams:

An investor in the 35% tax bracket is evaluating a tax-exempt municipal security with a tax-exempt yield of 4.5%. What is the taxable equivalent yield of the municipal security?

A. 2.9%
B. 6.9%
C. 12.9%

The answer is B.

The question here draws from the concept of how to arrive at taxable equivalent yield from a tax exempt yield. Currently, the tax exempt yield on the bond (let’s call it A) is 4.5%. Let’s further assume that there is another bond B that yields X but is not tax exempt. So for our investor to be indifferent to either investments the return to him/her from B after tax should be equal to the return from A.

In other words:
Yield on A = (1-tax rate)* Yield on B
4.5% = (1-35%)*X
X = 4.5% / 0.65  
X = 6.92%

Let’s try another example:

Bond X carries a rating of BBB-/Baa3. Bond Y has a rating of B/B2. Both bonds mature in ten years. Which bond’s value would be most affected by a ratings downgrade, and which bond has the higher default risk?

A. Bond X would be more affected by a ratings downgrade, but Bond Y has higher default risk. 
B. Bond Y would be more affected by a ratings downgrade, but Bond X has higher default risk. 
C. Bond X has higher default risk, but both bonds would experience similar effects of a ratings downgrade.

The correct answer here is A.

There are two distinct concepts being tested here:

  • Lower letter rating implies higher default risk. So Bond Y, on account of a lower letter rating, has a higher default risk. Also, worth mentioning here is that BBB- is a higher rating than B and Baa3 similarly is indicative of a higher rating when compared to B2.
  • BBB-/Baa3 is the lower most rating in the investment grade category. Any lower and the bond will move into High Yield territory. So a one notch downgrade would mean X moves from Investment grade territory to high yield territory. Typically when such an event happens a bond’s value is affected significantly more than in case of any other forms of rating down moves. This is because many investors are barred from holding high yield/speculative grade bonds by regulators leading to a sudden reduction in liquidity for that bond. Bond Y on the other hand is already in High Yield territory, so it is not as sensitive to a rating downgrade.

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Zee Tan
Author: Zee Tan


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