2013 CFA Level II Fixed Income

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Fixed Income Quiz (36 Questions, 108 Minutes)

The following information relates to Questions 1-6 Hayden Fritz, is an experienced investor who has primarily been investing in the local equities market for the past 10 years. Through a knack of spotting cheap stocks, prudent investing and a reasonable level of leverage, Hayden has managed to generate a satisfactory return over the years. However, as of late, an issue has been raised with regard to the regulation of the equities markets. This has coincided with a slowdown in the corporate earnings. As a result, Hayden has decided to tilt his portfolio towards high yield corporate debt instruments. Hayden contacts his broker who arranges a meeting on behalf of Hayden with the brokering firms fixed income analyst, Burtoch Wolfgang. During the meeting, Wolfgang explains to Hayden that he has identified two potential investments in a sector which has relatively outperformed the rest of the market and is in line with Haydens level of risk tolerance. Exhibit 1 Wolfgangs investment recommendations Debt characteristics Classification Term to maturity Coupon rate Nominal value (USD) Recovery rate Potential loss as % of nominal value Effective duration Modified Duration YTM Highfield Investments Senior secured 5 years 14% 10,000,000 80% 20% 3.2 3.5 12.5% Greenery Investments Senior secured 4 years 13.5% 15,000,000 60% 30% 2.5 2.8 11.3%

Describing the two investments, Wolfgang states that both firms operate in the Beverage Industry and are operationally very similar. Considering the firms debt structure, Wolfgang explains that in addition to its senior secured debt, Highfield Investments debt obligations also include $5 mn worth of senior subordinated debt and $7 mn senior unsecured debt outstanding. While satisfied with Wolfgangs findings, Hayden states that while fixed income as an asset class might be less risky as a whole when compared with equities, he concedes that a fair amount of analysis is required before making a firm commitment. Hayden is particularly concerned with market liquidity risk, credit migration risk and default risk and has described one of the risk factors faced by the firms as follows: Statement 1
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Both firms have similar debt outstanding and have similar credit ratings. While my average holding period for any investment is one to two years, Im worried about the fact that the majority of Highfield Investments Debt is not publicly traded unlike Greenery Investments. Wolfgang reassures Hayden that he has always been diligent and exhaustive in his analysis when it comes to his investment recommendations. His analysis encompasses credit analysis, liquidity analysis and yields and spread analysis. Wolfgang describes a particular type of analysis he conducted on Highfield Investments as follows: Statement 2 Highfield Investments has a young and dynamic management team which was installed three years back after a management shakeup. Since then, an impressive turnaround has been witnessed in the firms earnings and the firm has pursued a successful strategy of backward and forward integ ration. The new management is not afraid to accept large write-downs and adopt a more conservative approach as it moved away from the very aggressive accounting policies of the previous regime which held a significant amount of off-balance sheet financing. Wolfgang also states that he has conducted a thorough analysis of the two firms financial performance and studied the following metrics: Exhibit 2 Financial performance comparison Metric 5-year average standard deviation of operating margin 5-year average standard deviation of CFO FCF/Debt Debt/ EBITDA Cash & cash equivalents on balance sheet Net working capital *Figures in brackets indicate negative values Highfield Investments 3% 4.3% 35% 1.4x $ 760 mn $350 mn Greenery Investments 27% 32.1% 58% 0.6x $130 mn ($230 mn)*

In addition, Wolfgang has also conducted an analysis of the yield spreads of the two firms and its sensitivity to interest rate movements. Wolfgang expects an upward revision in the YTM of Highfield Investments senior secured debt due to an impending announcement of the issue of a further $2 mn of senior unsecured debt which he believes, could trigger a ratings downgrade. However, he believes that the effective and modified duration of the senior secured bond will remain unchanged. Satisfied with Wolfgangs research and expertise, Hayden decides to invest 70% of his funds in Highfield Investments senior secured debt and the remainder in Greenery Investment senior secured debt.
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1. Based on exhibit 1, Comparing the expected loss arising from Greenery investments senior secured debt with the expected loss arising from Highfield Investments senior secured debt, Greenery Investments expected loss is most likely: A. Higher by LKR 1.4 mn B. Lower by LKR 1.4 mn C. Lower by LKR 1.8 mn 2. The most appropriate Ranking of Highfield investments debt offerings from the highest to the lowest in terms of recovery rates is respectively: A. Senior secured, senior subordinated, senior unsecured B. Senior secured, senior unsecured, senior subordinated C. Senior subordinated, senior unsecured, senior secured 3. With respect to statement 1, Hayden is most likely concerned with: A. Market liquidity risk B. Credit migration risk C. Default risk 4. The type of analysis undertaken by Wolfgang described in statement 2, is most likely an assessment of the firms: A. Character B. Capacity C. Collateral 5. The least likely explanation for the divergence in the ratios presented by Wolfgang in exhibit 2 is: A. Highfield investments operates in a non-cyclical industry B. Highfield investments is more highly geared than Greenery investments C. Highfield investments has lower liquidity than Greenery investments 6. Based on exhibit 1 and Wolfgangs, return impact of an investment in Highfield Investments senior secured debt due to an instantaneous 50bps widening in spread is closest to: A. -1.75% B. 1.75% C. -1.60% The following information relates to Questions 7-12 Raj Chetty, CFA is a fixed income analyst at Adroit Investments; a private wealth management firm which focuses primarily on providing investment products with a tilt towards fixed income securities such as treasury securities & corporate bonds. Rajs manager Osha has convened a meeting of the investment committee to review its current investment products (Denoted portfolios A1, A2 & A3). During the meeting, Raj was called upon to present his view on his expectations on interest rate movements and yield curve shifts in the following 12-month period.
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Raj, in his review of the monetary policy developments of the economy concluded that the Central Bank had recently implemented some unorthodox policy measures involving the adjustment of treasury yields of different maturities in order to bring down the Average Weighted Prime Lending Rate (AWPLR) for corporate borrowers. This was done in order to boost investments and fuel economic growth which had witnessed a slowdown in the 4th quarter of 2012 due to declining disposable household income. As a result, Raj observed changes to the shape of the term structure of interest rates which he described as follows: Statement 1 I think, in the event of a policy revision that the yields towards the short end and the long end of the yield curve will increase faster than the intermediate maturity. Hence we should be mindful of this when implementing a yield curve positioning strategy for our fixed income Positions. Osha asks Raj to give a possible rationale for the shape of the yield curve to which Raj responds as follows: Statement 2 I think that while the yield curve reflects the markets expectations of future interest rates as well as a risk premium associated with holding longer dated maturities, I believe that the latter shares a nonlinear relationship with time to maturity. In other words, I believe that the risk premium will not rise in a linear fashion alongside maturity. Osha confides in Raj that she is worried that such changes to the term structure may have materially altered the returns of the funds holdings in zero coupon treasury securities. Raj replies that historically returns on such investments are influenced by parallel shifts in the yield curve, twists in the slope of the yield curve and changes to the humped-ness of the yield curve. Raj goes on to recommend to Osha and the rest of the investment committee that they should also begin to consider the Swap curve as an alternative benchmark, which has been gaining popularity as an alternative to the treasury spot rate curve. Raj makes the following arguments in favor of its implementation as part of the funds review process. Argument #1 Unlike investments in treasuries which may be regulated by governments, there is no regulation governing the swap markets and hence, using swap rates for comparison across markets is relatively easier. Argument #2
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Comparison with other markets is also made simple by the fact that swap rates reflect similar credit risk across markets unlike government yield curves which reflect different sovereign credit ratings After debating on the pros and cons of adopting the swap curve as a benchmark for the funds performance, Osha supplies the investment committee with details of the current mix of the funds three zero coupon treasury fixed income portfolios which are presented in exhibit 1. Exhibit 1 Composition of Tarshish funds fixed income portfolio Portfolio A1 80% 20% 100% Portfolio A2 40% 30% 30% 100% Portfolio 03 90% 10% 100%

2-year maturity 16-year maturity 30-year maturity Total

Having carefully considered the Central Banks stance on monetary policy in its latest monetary policy review as well as the IMFs report on the economys prospects, Raj states that he expects the following changes to the rates. Statement 3 The governments intention is to encourage greater long term investments. To this end I expect the key rate for the 2 year maturity to rise by 40 bps while I expect the key rate for the 30 year maturity to fall by 20 bps. After deliberating on whether the portfolios exposures should be altered based on Rajs expectations, the meeting is adjourned to next week. 7. The type of shift described in the yield curve in Raj statement 1 is most likely a: A. Positive Twist B. Positive butterfly C. Negative butterfly 8. The particular theory of the term structure of interest rates Raj explains in statement 2 is best described as the: A. Pure expectations theory B. Liquidity preference theory C. Preferred Habitat theory
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9. Of the factors mentioned by Raj which affect the shape of the yield curve, Osha should least likely be concerned with changes in the : A. Level of interest rates B. Shape of the yield curve C. Curvature of the yield curve 10. The arguments cited by Raj for the increased popularity of swap curves is most likely correct with respect to: A. Argument #1 & argument #2 B. Argument #1 only C. Argument #2 only 11. The portfolio with the lowest and highest portfolio duration, respectively: A. A1, A2 B. A1, A3 C. A2, A3 12. Assuming that Rajs expectations made in statement 3 are correct, the change in portfolio A1s value is closest to: A. +0.6% B. -0.6% C. +1.3% The following information relates to Questions 13-18 Lando Tung, is a high net worth investor who is considering taking a position in the Fast moving consumer goods (FMCG) sector of the economy as he believes that this sector has strong prospects, given the relative price inelasticity of the sectors products. Lando has indentified; Sartoni Foods; a retail chain which has a widespread distribution network and retail outlets spread in all parts of the country as a firm that is well poised to benefit from the growth in the FMCG sector. Lando outlines his investment strategy as follows: Statement 1 I am currently considering whether to invest in Sartoni foods equity or corporate debentures. In the case of the firms stock I would compare its price to earnings (P/E) multiple and price to book value (P/BV) multiple with the FMCG sectors average P/E and P/BV multiple before making a decision. In the case of debentures, the firm offers 5 year bonds with an embedded call option. I will compare an appropriate spread measure using a benchmark of a sector spot rate curve with the same credit rating as that of Sartonis. Subsequently, Lando discovers in his analysis of Sartoni Foods that a number of the firms corporate debentures are currently outstanding. Studying a number of reports on the firm, Lando comes across a sell side analyst who has estimated the spot rate curve for the firms debentures. Therefore Lando also considers using the issuers own spot rate curve as an appropriate benchmark.

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Having considered these various measures, Landos conclusion about the pricing of the Callable bond are summarized follows: Comparing the callable bond with the sector spot rate curve, the nominal spread was 180 bps vs. the benchmark of 130 bps while the OAS spread was Negative Comparing the callable bond with Sartonis own spot rate curve, the zero-volatility spread was 160 bps against the benchmark of 120 bps while the OAS spread was equal to zero.

Based on his analysis Lando decides that Sartonis callable bonds would be a more suitable investment over the firms equities. The rationale for his decision was described as follows: Statement 2 I expect interest rates to be more volatile over the next 12 months which has historically depressed equity values due to higher uncertainty. At the same time, the price of the callable bond in comparison to a straight bond is likely to fall due to a decrease in the value of the call option To determine the interest rate risk arising from his investment, Lando prepares the binomial tree for the callable bond adjusted for the changes to cash flow due to the exercise of the option. His findings are summarized below:
The callable bond with 5 years to maturity is currently trading at USD 98 with YTM of 9%. An increase in the YTM of Sartoni foods callable bond to 10% decreases the price to USD 94. A decrease in the YTM of Sartoni foods callable bond to 8% increases the price to USD 105.

The following day while reading the Business & Finance section of the daily newspaper, Lando discovered that Sartoni Foods are preparing to issue USD 2 mn worth of convertible bonds. The following is an extract of the terms of the convertible bonds which appeared in the newspaper: Exhibit 1 Sartoni foods callable bonds Par value Coupon rate Maturity date Non-callable period Market price of convertible bond Conversion ratio $ 1,000 9% 10 years 3 years $ 950 25

Exhibit 2 Sartoni foods equity Year of listing Total number of shares outstanding
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2008 500 mn
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Current price Dividend yield

$ 30 7%

Intrigued with this, Lando decides to compute the premium payback and the market conversion premium ratio to gauge this investment. 13. In statement 1, the most appropriate spread measure which would meet Landos requirement would be the: A. Nominal B. Zero-volatility C. Option-adjusted 14. Assuming that Lando uses the analysts chosen benchmark, a zero-volatilty spread measure would least likely compensate the investor for: A. Liquidity risk B. Credit risk C. Option risk 15. Based only on the comparison with the OAS spread, the conclusion Lando will most likely draw based on his findings of the value of the callable bond with respect to the sector spot rate curve and the OAS spread curve is respectively: A. Overpriced, Fairly priced B. Underpriced, Over priced C. Fairly priced, Under priced 16. Based on statement 2, Landos conclusions with respect to the price of the callable bond and the value of the call option is most likely correct with respect to: A. Both the price of the callable bond and the value of the call option B. The price of the callable bond only C. The value of the call option only 17. The effective duration and effective convexity of the callable bond for a 100bps change in interest rates is respectively: A. 2.8, 68 B. 3.4, -342 C. 5.6, 153 18. Based on the data presented in exhibit 1 & 2, the market conversion premium ratio for Sartoni foods convertible bond is closest to: A. 27% B. 15% C. 45% The following information relates to Questions 19-24

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Felix Baruch, CFA is a wealth manager with Guardian Corp, a private wealth management firm whose clients predominantly include small to medium scale universities and vocational training centers. The firm primarily invests in domestic and international equities and fixed income securities. Felix who manages the fixed income desk and whose current investment exposures include domestic and international sovereign debt and high yield corporate debt is hoping to expand its operations into the mortgage backed security sector. His team of analysts has prepared a summary document outlining the salient points of a potential investment it has identified for his review. The team outlines two potential mortgage backed securities issued by Galaxy Corp. The details of the investment are presented in exhibit 1: Exhibit 1 Mortgage backed Security description Security name Description Credit Rating Par value (USD) Passthrough rate Pool factor Average life (years) WAC WAM Nova Non-agency mortgage passthrough security A$3 mn 6.3% 0.82 11.4 7.2% 163 months

Felix is unfamiliar with some of the technical concepts like PSA benchmark and how they relate to the issue of prepayment risk. One of his analysts, Eddard, explains that these concepts are conventions used by market participants for describing the prepayment rate of a mortgage security. Eddard explains the relationship in the following two statements: Statement 1 The PSA benchmark is constructed on the assumption that prepayment rates are high for newly originated mortgages and then moderate overtime as they become seasoned. Statement 2 A 175 PSA would have a higher SMM rate compared with a 100 PSA all things being equal. Contemporaneously the average lifetime of the pass through security is positively related to the PSA speed The rest of the analysts report described the characteristics of Galaxy Corps Collateralized Mortgage Obligation (CMO). Felix is unfamiliar with some of the tranches described, specifically the tranche named as gamma which is described as follows:
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Statement 3 Tranche gammas payout is based on a notional amount of $500,000 where the coupon rate of 1.8% of the tranche is the difference between the collaterals coupon rate and the tranche coupon rate. What type of a tranche is this? Felix questions the team on some of the Pros and Cons of mortgage backed securities and on the teams expectations for future interest rates. Eddard reply to the question is as follows: Statement 4 With the downward revision in the Central Banks policy rates last December, the Central bank with its moral suasion has been pressuring commercial banks to lower borrowing costs in order to facilitate the governments infrastructure development agenda. I believe that the Central Bank will be successful in meeting its objective within the next 6 months Felix states that in addition to interest rates other factors which contribute to the prepayment rate must also be considered. 19. Which of the following least accurately describes the characteristics Felixs choice of non agency residential mortgage backed securities: A. Higher credit risk B. No access to credit enhancement mechanisms C. Structured as either passthroughs or CMOs 20. Based on the data in exhibit 1, the monthly servicing fee for security Nova is closest to : A. 0.01% B. 0.05% C. 0.08% 21. Eddards explanation concerning the PSA prepayment benchmark is most likely incorrect with respect to: A. Both Statement 1 and Statement 2 B. Statement 1 only C. Statement 2 only 22. Eddards best response to Felixs question in statement 3 is: A. Accrual tranche B. Structured Interest only (IO) tranche C. Interest only (IO) mortgage strip tranche 23. Based on Eddard expectations in statement 4, when investing in the passthrough security Felix should most likely be concerned with: A. Contraction risk B. Credit risk C. Extension risk

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24. Given Felixs worry over prepayment risk, the factor which is most likely to be a cause of an increase in prepayment risk is: A. Decline in spread between current mortgage rates and borrowers contract rate B. Increase in housing turnover due to increased economic growth C. Increase in legal fees and title insurance expenses The following information relates to Questions 25-30 Brandon Kerr is the owner of a chain of specialty comic book stores, QKR Comics, in the county in which he lives. Business has been flourishing lately with a renewed interest in mainstream comics due to recent popular TV shows and films on the subject matter. Brandon wishes to expand the number of stores over the coming years in order to cater to a wider audience. However the bulk of QKR Comics (Almost 80%) comes from the subscription fees of existing members who can lend comics at a deep discount and lend select comics for free. The membership involves a down payment as a joining fee followed by a renewal fee charged at the end of every calendar year. The fees are usually funded by QKR comics own revolving credit card system which is funded internally by QKR comics. As a result Brandon has considered securitizing the credit sales to raise additional cash for the expansion. Brandon makes the necessary arrangements with his lawyer to prepare the necessary legal documentation for the ABS program. The lawyer informs Brandon that he has drawn up the necessary documentation and only requires the document outlining the priority and amount of payments to the different classes of bondholders in the securitization structure. After having finalized the legal requirements, the draft of the securitization program summarizes the proposed changes to QKR Comics organization structure as follows: The new legal entity QKR guild will act as the Special purpose vehicle (SPV) for the ABS program QKR Comics will sell $130 mn worth of receivables to QKR Guild QKR Guild will issue bonds worth $100 mn to the public The cash raised from the sale of bonds will be returned to QKR Comics QKR Comics will retain the responsibility for servicing the above loans.

The bonds issued by QKR Guild will follow a sequential pay structure and is described as follows: Exhibit 1 QKR Guild ABS securities Bond class A1 (Senior) A2 (Senior) A3 (Senior) B0 (Subordinate) Total
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Par value ($ mns) $45 $20 $15 $20 $100

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Brandon also consults his cousin Lysa, who is a CFA charterholder and bond analyst for her opinion of the proposed QKR Guilds ABS securities structure. She states , that in order to improve the chances of the securities selling well, it should consider some internal credit enhancements in order to get a better credit rating. She goes on to state that some investors might worry about large prepayments of principal during the early days of the issues and may demand some safeguards. 25. The document requested by Brandons lawyer is most accurately described as the: A. Purchase agreement B. Servicing agreement C. Waterfall 26. The Seller, issuer and servicer of the securitization program by QKR is respectively: A. QKR Comics, QKR Guild, QKR Guild B. QKR Guild, QKR Comics, QKR Comics C. QKR Comics, QKR Guild, QKR Comics 27. Based on the structure in exhibit 1, in the event of a prepayment of $70 mn, the bond classes which are most likely to receive a payout are: A. A1, A2 and A3 only B. B0, and A2 only C. A1 and A2 only 28. Assuming default losses over the life of the structure is $30 mn the total loss borne by class B0 bondholders and class A1 bondholders is closest to: A. $ 30 mn B. $ 20 mn C. $ 0 mn 29. Based on the description of the ABS program, which of the following internal credit enhancement methods has QKR Comics currently not made use of: A. Excess spread account B. Overcollateralization C. Senior-subordinate structure 30. A possible solution for investors concerns with regard to prepayment risk would be the inclusion of a: A. First loss piece B. Lockout period C. Cap rate The following information relates to Questions 31-36 Richard and Abigail are two fixed income analysts working for Prima Facie Capital, a firm managing a number of unit trusts specializing in fixed income investments. One of the firms unit trusts denoted cloud 9 fund includes high yield emerging market sovereign and corporate bonds
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as well as mortgage backed and asset backed securities. Over a lunch date, the two analysts were debating over the Pros and Cons of the various valuation methods for securitized instruments. Richard stated that the most significant shortcoming of most valuation models is its inability to accurately model prepayment risk. In the case of passthrough securities, Richard states that the prime reason for this is that the prepayment rate for the current month depends on whether there have been any prior opportunities to refinance the mortgage. Abigail states that the nominal spread, Z-Spread and OAS spread are popular tools for valuation and capturing risk. She states that in the case of their sub fund Alpha which comprises exclusively of Mortgage passthrough securities issued by Ginnie Mae she makes use of the OAS spread. Abigail then shows Richard the latest quotes on the tranches of the firms sub fund Alpha. Tranche Beta 1 Beta 2 Delta 1 Delta 2 OAS spread (BPS) 60 75 65 25 Z-spread (bps) 75 90 85 50 Nominal spread (bps) 80 95 90 60

Richard comments on the fact that Tranche Delta 2 has a comparatively lower OAS spread. Abigail goes on to describe her experience with various duration methods. She states, that she has in the past made use of effective duration, cash flow duration and credit curve duration and makes the following observations Statement 1 The coupon curve duration while being simple to compute, its use is restricted to generic mortgage backed securities Statement 2 While the effective duration makes use of the Monte Carlo method for simulating prepayment risk, the cash flow duration method allows for cash flows to change based on the interest rate path and is therefore a superior method to the effective duration. Over dessert, Richard states that he is excited about the new fund Janus which fuses both mortgage backed securities with Asset backed securities (ABS). Richard asks for Abigails advice on a suitable valuation model for and ABS he is currently evaluating which is backed by credit card receivables.
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31. The phenomenon described by Richard on prepayment risk is most accurately described as:: A. Prepayment burnout B. Refinancing rate C. Prepayment multiplier 32. The OAS spread for Subfund Alpha most likely compensates an investor for: A. Credit risk B. liquidity risk C. option risk 33. Based on the data in exhibit 1, the option cost of Tranche Beta 1 is closest to: A. 60 bps B. 20 bps C. 15 bps 34. The least likely explanation for the value of Security Deltas OAS spread is that it has comparatively: A. Lower liquidity B. Lower modeling risk C. Lower credit risk 35. The statements made by Abigail with respect to the different measures of duration is least likely A. correct with respect to statement 1 B. Incorrect with respect to statement 2 C. Correct with respect to statement 1 and statement 2 36. The valuation method Abigail will most likely recommend to Richard, with respect to the ABS backed by credit card receivables is: A. Nominal spread approach B. Zero-volatility spread approach C. Option-adjusted spread approach

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