CFA Fixed Income Analysis 3 — Questions and Answers
Question 1: Which bond sector typically exhibits negative convexity at low yield levels?
- Investment-grade corporate bonds
- Mortgage-backed securities (Correct answer)
- Treasury inflation-protected securities
- Municipal revenue bonds
Correct answer: Mortgage-backed securities
MBS exhibit negative convexity because homeowners prepay mortgages when rates fall, causing the MBS price to underperform a straight bond.
Question 2: The forward rate f(2,1) represents the:
- 2-year spot rate one year from today
- 1-year rate two years from today (Correct answer)
- Rate on a 2-year bond issued 1 year ago
- Average of the 1-year and 2-year spot rates
Correct answer: 1-year rate two years from today
f(2,1) denotes the 1-year forward rate beginning 2 years from today, derived from the current spot rate curve.
Question 3: A portfolio manager wants to eliminate interest rate risk on a bond position. The most effective hedge using futures would be to:
- Buy futures contracts equal to the notional value of the bond portfolio
- Sell futures with a hedge ratio based on the portfolio's dollar duration (Correct answer)
- Buy put options on bond futures equal to portfolio duration
- Sell futures equal to one contract per $1 million of bonds
Correct answer: Sell futures with a hedge ratio based on the portfolio's dollar duration
The optimal futures hedge ratio accounts for the dollar duration of both the portfolio and the futures contract.
Question 4: When a yield curve flattens, a portfolio with a barbell structure will typically outperform a bullet portfolio because:
- The barbell has lower average duration
- Short and long bonds appreciate while intermediate bonds lag
- The barbell has higher convexity, benefiting from any yield change (Correct answer)
- Barbell portfolios have lower credit risk exposure
Correct answer: The barbell has higher convexity, benefiting from any yield change
Barbell portfolios have higher convexity than bullet portfolios with the same duration, providing outperformance regardless of the direction of yield curve shifts.
Question 5: In the context of credit analysis, a rising debt/EBITDA ratio combined with declining interest coverage most likely signals:
- Improving credit quality through leverage optimization
- Deteriorating ability to service debt, increasing default risk (Correct answer)
- Normal cyclical variation in a capital-intensive industry
- Positive leverage effect increasing return on equity
Correct answer: Deteriorating ability to service debt, increasing default risk
Rising debt/EBITDA with falling interest coverage indicates increasing leverage and reduced capacity to service debt, both negative credit signals.
Question 6: Which of the following features would most increase a bond's duration relative to an otherwise identical plain-vanilla bond?
- Embedded put option exercisable by the investor (Correct answer)
- Embedded call option exercisable by the issuer
- Sinking fund provision requiring annual principal repayment
- Convertibility feature at the investor's option
Correct answer: Embedded put option exercisable by the investor
A putable bond has longer effective duration because the put option shortens the bond's life only in rising rate scenarios, leaving duration longer than a callable bond.
Question 7: According to the CFA curriculum, the credit spread of a bond over Treasuries compensates investors for all of the following EXCEPT:
- Default risk
- Liquidity risk
- Duration risk (Correct answer)
- Loss given default
Correct answer: Duration risk
Duration risk is already captured in the Treasury yield itself; the credit spread compensates for default probability, LGD, and liquidity differences.
CFA Fixed Income Analysis 3
Which bond sector typically exhibits negative convexity at low yield levels?