CFA Level I: Fixed Income

Fixed income is a core pillar of the CFA Level I curriculum, typically representing about 11 to 14 percent of the exam. That weighting reflects how central bonds and other debt securities are to real-world investing. Governments fund budgets, companies finance growth, and households access credit, all through debt markets. For candidates, the fixed income topic set is less about memorizing definitions and more about understanding how bond cash flows translate into price, yield, and risk.

This article covers the main building blocks you are expected to know at Level I: bond characteristics, yield measures, risk measures, credit analysis, and securitization.

The building blocks: bond characteristics and cash flows

A bond is a contractual promise to pay cash flows. Most traditional bonds have:

• Par (face) value: the amount repaid at maturity.
• Coupon rate: the annualized interest rate applied to par.
• Coupon frequency: annual, semiannual, quarterly, etc.
• Maturity date: when principal is repaid.

From these inputs you can derive the cash flow schedule, which is the foundation for valuation. A plain-vanilla fixed-rate bond has predictable coupons plus a final principal payment. Other structures introduce different cash flow patterns:

• Zero-coupon bonds: no periodic coupons; issued at a discount and redeemed at par.
• Floating-rate notes (FRNs): coupons reset based on a reference rate plus a spread.
• Amortizing securities: principal is paid down over time, reducing interest payments later.
• Callable or putable bonds: embed options that can change the expected life and cash flows.

Level I focuses on recognizing how these features affect both price sensitivity and expected return. For example, a callable bond’s price tends to rise more slowly when rates fall because the issuer may refinance by calling the bond.

Pricing intuition: present value and the role of discount rates

Bond valuation is primarily discounted cash flow. The market price is the present value of expected cash flows discounted at the appropriate rate(s). Conceptually:

• Higher discount rates reduce present values, so bond prices fall when required yields rise.
• Longer maturities usually increase sensitivity to rate changes because cash flows occur further in the future.
• Higher coupons typically reduce interest rate sensitivity because more cash is received earlier.

Even without heavy computation, you should be comfortable with the basic relationship between price and yield: they move in opposite directions, and that relationship is nonlinear (convex).

Yield measures you must distinguish

“Yield” is not one number in practice. Level I expects candidates to understand multiple yield measures and what they represent.

Yield to maturity (YTM)

Yield to maturity is the single discount rate that makes the present value of promised cash flows equal to the bond’s current price. It is commonly interpreted as a bond’s internal rate of return if:

1. the bond is held to maturity,
2. all coupons are reinvested at the same yield, and
3. the issuer does not default.

YTM is widely quoted, but it is not a guaranteed realized return because reinvestment rates and credit outcomes can differ.

Current yield

Current yield is a simpler income measure:

• annual coupon payment divided by the bond’s price.

It ignores capital gains or losses from pull-to-par and is therefore less informative for total return.

Yield to call and yield to worst

When a bond is callable, yield to call assumes the bond will be redeemed at the call date and call price. Market practice often reports yield to worst, the lowest yield across relevant redemption scenarios (maturity, call dates, puts). The key idea is that embedded options change the horizon over which you earn returns.

Spot rates and forward rates (conceptual at Level I)

While Level I does not require deep curve-building mechanics, you should understand that:

• Spot rates discount individual cash flows at each maturity.
• Forward rates are implied future rates consistent with today’s spot curve.

These concepts matter because a single YTM can mask differences in term structure across maturities.

Risk measures: interest rate risk and beyond

Fixed income risk is often dominated by interest rate movements, but it is not limited to them. Level I concentrates on the standard quantitative measures of price sensitivity.

Duration: the first-order sensitivity

Duration is an estimate of how much a bond’s price changes for a small change in yield. In practical terms, it translates yield changes into approximate percentage price changes.

Two common interpretations:

• Macaulay duration: a weighted-average time to receive the bond’s cash flows.
• Modified duration: a price sensitivity measure (approximately the percentage change in price for a 1% change in yield).

A key relationship you should understand is:

$$\frac{\Delta P}{P}\approx -D_{\text{mod}}\Delta y$$

where $D_{\text{mod}}$ is modified duration and $\Delta y$ is the change in yield.

Duration increases with longer maturity and lower coupon, and it generally decreases as yield increases.

Convexity: the curvature adjustment

Because price-yield relationships are curved, duration alone becomes less accurate for larger yield changes. Convexity improves the approximation by accounting for curvature:

• Bonds with higher convexity tend to lose less when yields rise and gain more when yields fall, all else equal.
• The combination of duration and convexity is a better tool for comparing interest rate risk.

Key rate and curve risk (conceptual awareness)

Even at Level I, it is helpful to think beyond a parallel shift in yields. Real yield curves twist and change shape. A portfolio can have similar overall duration to another but behave differently if rate changes are concentrated in one part of the curve. This is the intuition behind key rate duration, even if calculations are not emphasized.

Other major fixed income risks

You are expected to recognize additional sources of risk that affect pricing and required yields:

• Credit (default) risk: the issuer may fail to make promised payments.
• Liquidity risk: selling quickly may require a price concession.
• Reinvestment risk: coupons may be reinvested at lower rates than expected.
• Inflation risk: real purchasing power of nominal cash flows may erode.
• Call/prepayment risk: cash flows shorten when rates fall, limiting upside.

Credit analysis: why spreads exist

Credit analysis at Level I focuses on the link between issuer fundamentals and the extra yield investors demand above a “risk-free” benchmark.

Understanding credit spreads

A credit spread is the yield difference between a credit-risky bond and a benchmark of similar maturity (often a government bond). Spreads compensate investors for:

• expected default losses,
• uncertainty around recovery,
• liquidity differences, and
• risk premia that vary with market conditions.

Spreads typically widen when risk aversion rises and narrow when markets are confident.

Ratings and their limits

Credit ratings summarize an agency’s view of default risk, but they are not guarantees. Two bonds with the same rating can trade at different spreads due to structure, liquidity, seniority, and sector dynamics. At Level I, the important skill is interpreting ratings as one input among many, not a substitute for analysis.

Capital structure and seniority

Bondholders’ expected recovery depends on where a bond sits in the issuer’s capital structure. Senior secured debt generally has higher recovery prospects than subordinated unsecured debt. Even before you study deeper credit models in later levels, you should connect seniority and collateral to required yields.

Securitization: turning pools of loans into securities

Securitization is a distinct fixed income segment with unique cash flow behavior. The core idea is simple: a sponsor pools financial assets such as mortgages, auto loans, or credit card receivables and issues securities backed by the cash flows of that pool.

Asset-backed securities (ABS) and mortgage-backed securities (MBS)

• ABS are backed by non-mortgage assets like auto loans or receivables.
• MBS are backed by residential or commercial mortgages.

These securities often have prepayment risk, meaning borrowers can repay principal early. When interest rates fall, refinancing incentives rise, and prepayments can accelerate. This changes the timing of cash flows and can reduce the investor’s ability to benefit from falling rates.

Tranching and credit enhancement (high-level)

Many securitizations issue multiple tranches, which allocate cash flows and losses in a prioritized order. Senior tranches are paid first and generally have lower credit risk than subordinated tranches. Structures may also use credit enhancement features (such as subordination) to improve the credit profile of senior notes. At Level I, focus on understanding why tranches can have different risk and yield even though they are backed by the same asset pool.

How to study fixed income effectively for Level I

To perform well, tie every formula back to economic intuition:

1. Start with bond cash flows and present value.
2. Understand the price-yield tradeoff and why it is curved.
3. Use duration and convexity to compare interest rate risk.
4. Layer in credit spreads and credit fundamentals.
5. Treat securitized products as cash flow timing problems driven by prepayment and structure.

Fixed income can feel technical, but it is highly logical. Once you can translate a security’s features into cash flow timing and discount rates, the rest of the topic becomes a structured set of risk and return tradeoffs, exactly the perspective the CFA Program aims to develop.