Table of Contents
CFA Level 3 – Fixed Income, Session 10 – Reading 24
(Notes, Practice Questions, Sample Questions)
1. Which of the following best describes the basis for relative-value analysis?
A)Generates rankings of expected returns. {Explanation — Relative value refers to the ranking of fixed-income investments by sectors, structures, issuers, and issues in terms of their expected performance during some future interval}
B)Identifies mispricings.
C)Identifies the value of corporate bonds relative to government bonds
2. Which of the following is the major emphasis of the bottom-up approach of classic relative-value analysis? Identifying:
A)individual issues that are expected to outperform their peer groups. {Explanation — Bottom-up approaches focus on security by security analyses in the attempt to find those individual issues expected to outperform others}
B)high-convexity issues.
C)optimal allocations to individual issuers
3. In the bond market, relative-value analysis refers to the:
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A)relative market value of each holding to the total value of the portfolio.
B)methodologies employed to generate rankings of fixed income securities according to various attributes such as sectors and expected performance. {Explanation — Relative-value analysis refers to several related methodologies used to rate and rank fixed-income securities}
C)relative risk and return characteristics between a corporations’ common stock and its debt issues
4. In classic relative-value analysis the top-down approach refers to:
A)ranking the holdings in a corporate bond portfolio according to the relative market value of each asset class, beginning with the highest value.
B)looking for undervalued assets and ranking them from most to least undervalued.
C)using large-scale economic information to allocate funds to various corporate asset classes {Explanation — Large scale (i.e. macro) economic information concerns data such as inflation, interest rate changes, and the level and direction of the overall economy (both domestic and foreign). Top-down analysis seeks to allocate funds to those issues that would benefit the most from the expected large-scale economic changes/trends}
5. Which of the following is an example of a bottom-up approach of classic relative value analysis that would indicate an undervalued issue?
A)Due to continued strong earnings growth of XMP Corporation, their bond’s credit rating is expected to be upgraded. The manager of a corporate bond portfolio does not believe this is reflected in the current market value. {Explanation — If a bond’s credit rating is upgraded, the required yield will decline and the market value of the bond will increase. If this event is not currently reflected in the value of the bond then it represents an undervalued security}
B)The manager of a corporate bond portfolio expects the increased debt usage of Corey, Inc., together with the prospect of greater competition and lower profit margins, will lead to a decrease in the credit rating of Corey bonds. These expectations are not reflected in the current market value of the bonds.
C)General economic conditions indicate the inflation rate will decline over the next year, with the expectation this will result in reducing the required yield for outstanding bonds in all maturity classes.
6. Which of the following statements about cyclical and secular changes in the primary bond market is least accurate?
A)One factor that can cause structural changes in the bond market is the desire of issuers to minimize financing costs under different yield curve and spread scenarios.
B)Structural changes in the composition of the bond market can occur rapidly. {Explanation — Structural changes occur slowly and have long-term implications for bond portfolio investment decisions. These changes are the result of issuers attempting to minimize their funding costs under different yield curve and spread scenarios}
C)Relative corporate bond returns frequently perform best when the supply of bonds is relatively plentiful.
7. Investors that are willing to give up additional return in exchange for increased liquidity are least likely interested in which of the following types of bonds:
A)private placements. {Explanation — Many investors are willing to give up additional return in exchange for greater liquidity. Private placement issues typically have relatively low liquidity}
B)large-sized issues.
C)Treasury issues.
8. The ability to buy or sell quickly at a fair price is best described by which of the following terms?
A)Liquidity. {Explanation — Liquidity is the ability to buy or sell quickly at a fair price}
B)Efficiency.
C)Marketability.
9. Which of the following statements about the rationale for trading in the secondary bond market is least accurate?
A)Altering the duration of a portfolio because of anticipated yield curve changes is labeled a curve adjustment trade.
B)The popularity of credit-defense trades is not related to expected levels of economic uncertainty. {Explanation — Credit-defense trades result from a bond manager’s desire to reduce the portfolio’s exposure to expected credit downgrades. As such, during periods of anticipated economic uncertainty, credit-defense trades normally increase}
C)The reason to engage in a sector-rotation trade is to shift out of a sector that is expected to underperform on a total return basis, and buy into a sector that is expected to outperform in total return.
10. Which of the following is the best rationale for purchasing an issue in the secondary market?
A)High-default rates in a particular sector.
B)Expectations of an upgrade in an issuer’s credit quality. {Explanation — An upgrade in credit quality will result in less credit-premium demanded by investors. Since discount rates and prices move in opposite directions for bonds, credit upgrades will result in an increase in price that will generate a greater total return from the investment}
C)Increasing credit risk for a particular bond.
11. Estimates are that more than 50% of all secondary bond trading is due to which type of trade?
A)Curve adjustment.
B)Yield/spread pickup. {Explanation — The motivation behind yield/spread pickup trades is to increase yield within specified duration and credit quality bounds. This motivation is estimated to account for more than 50% of all secondary trades}
C)New issue swaps.
12. Expectations that an issue will experience a quality upgrade that is not already reflected in the current spread could result in which type of trade?
A)Sector rotation.
B)Credit defense.
C)Credit-upside. {Explanation — A credit-upside trade is motivated by a bond portfolio manager’s expectation that an issuer will experience a credit upgrade, and belief that this is not already reflected in the market value of the issue}
13. On-the-run Treasuries are frequently perceived to have superior liquidity. Based on this rational, many bond managers engage in:
A)curve adjustment trades.
B)new issue swaps. {Explanation — Relatively large new issues, particularly Treasuries that have just been issued (on-the-run), are believed to have superior liquidity—a rationale for including more of them in the portfolio}
C)credit defense trades
14. Which of the following strategies would normally result in the best bond performance?
A)Buy callable bonds rather than bullets, if a strong bullish bond market is expected.
B)If a bear bond market is expected, buy callable bonds instead of bullets. {Explanation — Callable bonds generally outperform bullets in a bear bond market because the probability of a call is reduced. As interest rates increase, the value of the embedded option decreases, with a resultant decrease in the differential yield between callable and noncallable bonds. In a bull bond market the call option acts as a resistance point limiting the price appreciation of callable bonds}
C)Buy callable bonds when interest rates decline.
15. In terms of a long-term investor, which of the following is a potential criticism of not investing in securities with low liquidity? These securities:
A)offer arbitrage opportunities more frequently.
B)are less risky.
C)have to provide higher returns as a compensation for low liquidity. {Explanation — Less liquid securities must provide a liquidity premium to compensate for the low liquidity}
16. Which of the following is a potential criticism of a strategy that invests in securities that are “neglected” by the market? This type of security:
A)often has low liquidity. {Explanation — Since these securities are “neglected,” liquidity is low and transaction costs high}
B)has a lower risk-return tradeoff.
C)is often overpriced.
17. Which of the following statements about swaps is CORRECT?
A)A swap spread is the spread paid by the fixed-rate payer over the seasoned Treasury rate.
B)In the European market, swap spreads serve as a good proxy for credit spreads. {Explanation — It is because of the relative homogeneity of the European bond market that swap spreads are a good proxy for credit spreads. European issues are generally high in quality and intermediate in maturity. Swap spreads involve the on-the-run Treasury rate, not seasoned issues}
C)A swap spread refers to the difference in yield between corporate issues of different quality ratings.
18. Which of the following statements about spread analysis is CORRECT?
