CPM Fixed Income Portfolio Management 2 — Questions and Answers
Question 1: The yield curve typically slopes upward in normal market conditions because:
- Short-term bonds are riskier than long-term bonds
- Investors require a higher return for bearing greater interest rate risk over longer time horizons (Correct answer)
- Central banks keep all yields equal
- Inflation is always expected to fall
Correct answer: Investors require a higher return for bearing greater interest rate risk over longer time horizons
A normal upward-sloping yield curve reflects the liquidity preference and term premium — investors demand higher yields for lending money over longer periods due to greater uncertainty.
Question 2: Credit risk in a bond portfolio is most directly managed by:
- Increasing duration
- Diversifying across issuers, sectors, and credit ratings (Correct answer)
- Concentrating in a single high-quality issuer
- Eliminating all floating rate bonds
Correct answer: Diversifying across issuers, sectors, and credit ratings
Credit risk is reduced through diversification across many issuers and sectors, limiting the impact of any single issuer default on the overall portfolio.
Question 3: What does an inverted yield curve typically signal?
- Strong economic growth is expected
- A recession is likely, as short-term rates exceed long-term rates (Correct answer)
- Inflation is expected to rise sharply
- Central banks are easing monetary policy
Correct answer: A recession is likely, as short-term rates exceed long-term rates
An inverted yield curve, where short-term rates exceed long-term rates, has historically been a reliable leading indicator of economic recession.
Question 4: A bond portfolio manager using a laddered strategy:
- Concentrates all bonds in one maturity bucket
- Spreads bond maturities evenly across multiple intervals, providing regular reinvestment opportunities (Correct answer)
- Uses only zero-coupon bonds
- Maximizes duration at all times
Correct answer: Spreads bond maturities evenly across multiple intervals, providing regular reinvestment opportunities
A laddered portfolio holds bonds with evenly spaced maturities, so as each bond matures, the proceeds can be reinvested at current rates, reducing reinvestment risk.
Question 5: The yield to maturity (YTM) of a bond assumes:
- All coupons are reinvested at the current market rate
- All coupons are reinvested at the YTM rate and the bond is held to maturity (Correct answer)
- No reinvestment of coupon payments
- The bond will be called early
Correct answer: All coupons are reinvested at the YTM rate and the bond is held to maturity
YTM assumes all coupon payments are reinvested at the same YTM rate and the investor holds the bond until it matures — if either condition is violated, realized return will differ.
Question 6: Which of the following best describes a callable bond's key risk for investors?
- The bond may default
- The issuer will call the bond when rates fall, forcing reinvestment at lower rates — this is call risk (Correct answer)
- The bond cannot be traded
- Duration increases significantly when rates fall
Correct answer: The issuer will call the bond when rates fall, forcing reinvestment at lower rates — this is call risk
Callable bonds give the issuer the right to redeem the bond early, typically when interest rates decline, leaving investors to reinvest proceeds at lower prevailing rates.
CPM Fixed Income Portfolio Management 2
The yield curve typically slopes upward in normal market conditions because: