CFA L1 Fixed Income: practice questions with answers

Answer: A. Affirmative covenants state what the issuer must do (pay interest and principal, maintain insurance and assets, comply with laws, report to the trustee). Negative covenants state what the issuer must not do, protecting bondholders from actions that dilute their claim or raise risk, such as restrictions on additional debt, negative pledges, limits on asset sales and restrictions on distributions. A cap on new senior debt tied to a leverage ratio is a negative covenant.

Answer: A. An issuer rating reflects the risk of the issuer's senior unsecured debt. Individual issues are notched up or down from it according to their priority of claims: secured debt may be rated higher, and subordinated debt lower, because subordinated holders recover less in default. BBB- is the lowest investment-grade rating, so notching a subordinated issue down from BBB- would most likely put it in speculative (high-yield) grade.

Answer: A. There are many thousands of corporate bond issues, most of which trade infrequently, so a central exchange order book is not practical. Secondary trading is mainly over the counter: investors trade with dealers (increasingly through electronic platforms) who quote bid and offer prices and carry inventory. The bid-offer spread is the dealer's compensation and is a measure of liquidity: it is narrow for large, recent, highly rated issues and wide for small, old or lower-rated issues.

Answer: C. A spot rate for maturity T is a geometric average of the 1-period forward rates up to T. If spot rates rise with maturity, each additional forward rate must be above the current spot rate, so the forward curve lies above the spot curve.
A par rate is the coupon rate that prices a bond at par using all the spot rates up to maturity, so it is a weighted average of those spot rates, with most weight on the final cash flow. With an upward-sloping spot curve, the earlier (lower) spot rates pull the par rate below the spot rate for the same maturity. Order for an upward-sloping curve: par < spot < forward.

Answer: B. A sovereign's credit quality depends on both its ability to pay (economic strength, fiscal position, external position, monetary flexibility) and its willingness to pay. Willingness matters because sovereign immunity means bondholders usually cannot seize assets or force a government to pay through the courts.
Analysts assess willingness through the institutional and political assessment: the effectiveness and stability of institutions, the rule of law, respect for contracts and property rights, and the government's track record of honoring its debts. A history of restructuring debt when the government could have paid is a strong signal of weak willingness to pay, which leads to lower ratings and higher yields.

Answer: C. A yield on a semiannual bond basis is twice the semiannual periodic rate: 6.40% / 2 = 3.20% per half-year.
Equivalent annual-compounding yield = (1 + 0.032)^2 - 1 = 1.065024 - 1 = 6.50%.
The more frequent the compounding, the lower the stated annual rate needed for the same effective return, so the annual-basis yield is above 6.40%.