CFA Level I Fixed Income Practice Questions
Question 1
Bonds A, B, and C are identical in maturity, coupon rate, and payment frequency, differing only in credit rating: Bond A is rated AAA, Bond B is rated BBB, and Bond C is rated B (speculative grade). All else equal, which bond should trade at the highest yield spread over a comparable-maturity Treasury security?
- A. Bond C
- B. Bond A
- C. Bond B
- D. All three bonds should have identical spreads since they have identical maturities and coupons
Show answer and explanation
Correct answer: A. Bond C
Yield spread over a benchmark Treasury primarily compensates investors for credit (default) risk, along with liquidity and other risk factors. Lower-rated issuers have a higher probability of default and typically lower recovery expectations, so investors demand a larger spread as compensation. Bond C, rated B (speculative/high-yield grade), carries materially more credit risk than investment-grade Bonds A (AAA) and B (BBB), so it should command the widest spread. Choice D incorrectly assumes that matching maturity and coupon eliminates credit-risk differentiation — it does not, since spread compensates specifically for the risk the coupon and maturity terms don't capture.
- A. Bond C, the speculative-grade (B-rated) issue, carries the highest default risk of the three, so investors demand the largest yield spread over Treasuries to compensate.
- B. Bond A's AAA rating reflects the lowest credit risk of the group, so it should trade at the smallest spread over Treasuries, not the largest.
- C. Bond B's BBB (investment-grade) rating sits between AAA and B, so its spread should be intermediate — higher than Bond A's but well below Bond C's.
- D. Credit spreads compensate specifically for default and credit risk, which differs sharply across the AAA/BBB/B ratings here even though maturity and coupon are identical.
Question 2
A corporate bond's government benchmark yield falls 20 basis points but its credit spread widens 45 basis points. If duration is 4 and convexity is ignored, how should its price change approximately?
- A. Stay unchanged because the yield fall offsets the spread widening
- B. Decline 2.6% because spread changes dominate benchmark changes
- C. Increase 1.0% because government yields fell
- D. Decline 1.0% because all-in yield rises 25 basis points
Show answer and explanation
Correct answer: D. Decline 1.0% because all-in yield rises 25 basis points
The bond's all-in yield change is -20 + 45 = +25 basis points, so the price change is about -4 x 0.0025 = -1.0%.
- A. The 20 basis point decline does not fully offset the 45 basis point spread widening; the net move is up 25 basis points.
- B. Ignoring the benchmark decline overstates the loss; the spread alone would imply about 1.8%, and the net move is smaller.
- C. This counts only the benchmark yield decline and ignores the larger spread widening.
- D. Net yield rises 25 basis points, and duration of 4 gives roughly a 1.0% price decline.
Question 3
In a sequential-pay CMO structure with Tranches A, B, and C, principal payments (scheduled principal plus prepayments) are directed:
- A. First to Tranche A until it is fully retired, then to Tranche B, then to Tranche C
- B. Pro-rata across all tranches based on each tranche's outstanding balance
- C. First to Tranche C, to shield the shortest tranche from prepayment risk
- D. To whichever tranche currently carries the highest coupon rate
Show answer and explanation
Correct answer: A. First to Tranche A until it is fully retired, then to Tranche B, then to Tranche C
In a sequential-pay structure, all principal (scheduled and prepaid) flows to the earliest, shortest-maturity tranche first; only after Tranche A is fully retired does principal begin flowing to Tranche B, and so on. This redistributes prepayment risk across tranches by average life rather than eliminating it. Choice B describes a pro-rata (not sequential) structure. Choice C reverses the payment order. Choice D introduces an irrelevant criterion — coupon rate does not determine principal allocation in a sequential-pay deal.
- A. Correct — in a sequential-pay structure, all principal (scheduled plus prepaid) flows to the earliest tranche (A) until fully retired, then to B, then to C, concentrating prepayment risk in order.
- B. Incorrect — pro-rata principal allocation describes a different structure, not the defining sequential-pay mechanism, which retires tranches one at a time in priority order.
- C. Incorrect — this reverses the actual priority; Tranche C is last, not first, to receive principal, making it the longest and most prepayment-protected tranche rather than the shortest.
- D. Incorrect — principal allocation in a sequential-pay CMO is driven by tranche seniority, not by which tranche happens to carry the highest coupon.
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A bond has an effective duration of 7 and effective convexity of 60. If the bond's market yield rises by 100 basis points, the estimated percentage change in the bond's price, incorporating both the duration and convexity effects, is closest to:
- A. -7.30%
- B. -7.00%
- C. -6.70%
- D. -6.10%
Show answer and explanation
Correct answer: C. -6.70%
The full duration-and-convexity price-change approximation is %ΔP ≈ [−Duration × Δy] + [0.5 × Convexity × (Δy)²]. Here: −7 × 0.01 = −0.07 (−7.00%), and 0.5 × 60 × (0.01)² = 0.003 (+0.30%). Adding these gives −0.07 + 0.003 = −0.067, or approximately −6.70%. Positive convexity always makes the actual price decline smaller (less negative) than the duration-only estimate for a yield increase.
- A. Incorrect — this subtracts the convexity adjustment instead of adding it, reversing its sign for a bond with positive convexity.
- B. Incorrect — this is the duration-only estimate, omitting the convexity adjustment entirely.
- C. Correct — combines the duration effect (−7.00%) with the positive convexity adjustment (+0.30%) to get −6.70%.
- D. Incorrect — overstates the convexity adjustment's magnitude beyond what 0.5 × 60 × (0.01)² actually produces.