Fixed income instrument features (for the CFA Level 1 exam)

Introduction

This tutorial provides a comprehensive overview of the key features of fixed income instruments, vital for anyone preparing for the CFA Level 1 exam. Understanding these fundamental parameters will help you grasp how different debt securities function and how they are classified.

Step 1: Understand Issuer Type

• Identify the types of issuers of fixed income instruments, which include:
  • Government entities (federal, state, municipal)
  • Corporations (public and private companies)
  • Supranational organizations (e.g., World Bank)
• Recognize that the issuer type influences the risk and return profile of the instrument:
  • Government bonds are typically considered lower risk.
  • Corporate bonds may offer higher returns but come with increased risk.

Step 2: Learn About Maturity

• Define what maturity means in the context of fixed income securities:
  • Maturity is the date when the principal amount of the bond is due to be paid back to the bondholder.
• Classify bonds based on maturity:
  • Short-term (less than 3 years)
  • Medium-term (3 to 10 years)
  • Long-term (more than 10 years)
• Note that maturity affects interest rates and price volatility:
  • Longer maturities typically have higher yields but greater price fluctuations.

Step 3: Familiarize with Principal or Par/Face Value

• Understand the terms principal, par value, and face value:
  • These terms refer to the amount the bond issuer agrees to pay the bondholder at maturity.
• Recognize that the par value is usually set at $1,000 for corporate bonds:
  • This amount is important for calculating coupon payments and yields.

Step 4: Grasp Seniority

• Define seniority in the context of debt instruments:
  • Seniority refers to the order of claims on the issuer's assets in the event of liquidation.
• Identify the types of debt based on seniority:
  • Senior debt: paid first in bankruptcy proceedings
  • Subordinated debt: paid after senior debt
• Understand how seniority affects risk and return:
  • Senior debt usually has lower yields but is less risky.

Step 5: Review Contingency Provisions

• Explain contingency provisions in fixed income securities:
  • These are clauses that outline specific conditions under which changes may occur.
• Common types of provisions include:
  • Call provisions: allow the issuer to repay the bond before maturity.
  • Put provisions: allow bondholders to sell the bond back to the issuer under certain conditions.
• Recognize how these provisions can affect investment decisions and yields.

Conclusion

Understanding the features of fixed income instruments is crucial for your CFA Level 1 exam preparation. Focus on the issuer type, maturity, principal value, seniority, and contingency provisions to build a solid foundation in fixed income securities. As you continue your studies, consider practical applications of these concepts in real-world investing to further enhance your understanding.