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CFA Level 3 Fixed Income: The Strategies That Separate Passes From Fails

Level 2 Fixed Income goes far beyond duration and yield to maturity. Spread measures, MBS valuation, liability-driven investing, and active yield curve strategies are the four areas where most marks are won or lost. This guide covers all four in depth.

CFA Level 2 Fixed Income builds on the Level 1 foundations — bond pricing, duration, yield measures — and extends into territory that is both more technically demanding and more directly relevant to professional investment practice. The four areas that generate the most exam questions and the most candidate difficulty are: spread measures (Z-spread, OAS, and their differences), mortgage-backed securities (valuation, prepayment risk, and tranche structures), liability-driven investing (immunisation strategies and duration matching), and active yield curve strategies.

Candidates who have a solid Level 1 foundation and invest focused time in these four areas are well-positioned to score strongly in Level 2 Fixed Income. Candidates who try to approach Level 2 Fixed Income as an extension of Level 1 revision — more of the same, just deeper — often find themselves surprised by how different the application-level testing feels.

10–15%
Level 2 exam weight
4
High-yield sub-topics
L3
Builds heavily into LDI at Level 3

Area 1: Spread Measures — Z-Spread vs OAS vs G-Spread

Yield spreads measure the additional yield a bond offers over a benchmark to compensate for credit risk, liquidity risk, and embedded option risk. The Level 2 exam tests three spread measures in depth and requires you to understand what each measures, how each is calculated, and how they relate to each other.

Spread Measures Compared
G-Spread (Government Spread)

Yield spread over the government bond with the same maturity. Simple but imprecise — it does not account for the shape of the yield curve between the two bonds.

I-Spread (Interpolated Spread)

Yield spread over the swap rate at the same maturity. Used when no government bond with exactly the same maturity exists; the swap rate provides a smoother benchmark.

Z-Spread (Zero-Volatility Spread)

The constant spread added to every point on the spot rate curve that makes the present value of cash flows equal to the market price. More accurate than G-spread because it incorporates the full term structure. Assumes no interest rate volatility.

OAS (Option-Adjusted Spread)

The Z-spread adjusted to remove the value of any embedded option. For a callable bond: OAS = Z-spread − Option Value. OAS measures the compensation for credit and liquidity risk only — it strips out option effects. For non-option bonds: OAS = Z-spread.

The Key Relationship
For callable bonds: Z-spread > OAS (the call option has positive value to the issuer, which reduces the spread the investor receives net of option effects). For putable bonds: OAS > Z-spread (the put option has positive value to the investor, so stripping it out results in a higher OAS). For non-callable/non-putable bonds: OAS = Z-spread.

Area 2: Mortgage-Backed Securities — Prepayment Risk and Tranche Structures

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MBS valuation is one of the most conceptually distinctive topics in Level 2 Fixed Income because of prepayment risk — the risk that homeowners will repay their mortgages early (typically when interest rates fall and they refinance). Prepayment creates negative convexity: the bond's price appreciation is capped when rates fall because rising prepayments return principal to investors at par, just when they would prefer to hold the high-coupon bonds.

Prepayment Measures
SMM (Single Monthly Mortality) = (Prepayment in month t) / (Beginning balance − Scheduled principal)
CPR (Conditional Prepayment Rate) = 1 − (1 − SMM)^12 [Annual rate]
PSA Benchmark: 100% PSA = 0.2% CPR increasing to 6% CPR over 30 months
150% PSA means prepayment is 1.5× the benchmark rate

CMO tranche structures redistribute prepayment risk across investor groups. The key tranche types:

  • Sequential Pay: Tranches receive principal sequentially — Tranche A receives all principal until paid off, then Tranche B begins receiving principal. Each tranche has a different effective maturity.
  • PAC (Planned Amortization Class): PAC tranches have a defined principal payment schedule that is maintained across a range of prepayment speeds (the PAC band). Support/companion tranches absorb prepayment variability above and below the band — they have the highest prepayment risk.
  • Interest-Only (IO) and Principal-Only (PO): IO strips receive only interest; their value falls when rates drop (because prepayment increases, reducing the interest stream). PO strips receive only principal; their value rises when rates drop (because prepayment accelerates, returning principal faster).

Area 3: Liability-Driven Investing and Immunisation

LDI strategies are used by pension funds, insurance companies, and other entities with defined future liabilities to manage interest rate risk. The goal is to structure the asset portfolio so that changes in interest rates affect assets and liabilities equally — immunising the funded status from rate movements.

Immunisation Strategies
Cash Flow Matching

Match asset cash flows exactly to liability payment dates. Eliminates both interest rate risk and reinvestment risk. Most precise but most expensive — requires purchasing specific bonds to match each liability date.

Duration Matching (Classical Immunisation)

Match portfolio duration to liability duration and set PV(assets) ≥ PV(liabilities). Eliminates interest rate risk but leaves reinvestment risk — if rates change, the reinvestment rate on coupon cash flows changes. Less precise but more flexible and cheaper than cash flow matching.

Contingent Immunisation

Active management is pursued while the surplus exceeds a safety margin. If the surplus falls to the trigger level, the portfolio switches to full immunisation. Allows potential upside from active management while limiting downside.

Area 4: Active Yield Curve Strategies

Active fixed income managers who have views on how the yield curve will move use specific strategies to position their portfolios to benefit. The Level 2 exam tests five primary yield curve strategies:

  • Bullet: Concentrate portfolio around a single maturity. Benefits when that maturity's yield falls relative to others (steeper or flatter curve on either side).
  • Barbell: Concentrate at short and long maturities. Benefits when the curve flattens (short yields rise relative to long yields) or when long-end volatility supports the longer bonds.
  • Laddered: Distribute evenly across maturities. Provides diversification across the curve and consistent reinvestment opportunities.
  • Duration Extension: Lengthen portfolio duration to benefit from falling long-term rates.
  • Curve Flattener/Steepener: Relative value bets on specific segments of the curve — long the segment expected to outperform, short the segment expected to underperform.
Exam Application
The exam presents a portfolio manager's yield curve view — e.g., "expects the yield curve to flatten" — and asks you to identify which strategy best expresses that view and why. Know the scenarios: parallel shift (duration bet), twist/flattening (barbell vs bullet), and steepening (reverse barbell). The Federal Reserve's H.15 interest rate release is a useful real-world reference for understanding yield curve dynamics.

Level 2 Fixed Income is one of the topics most worth investing heavily in, not just for the exam marks but because the material recurs directly in Level 3 — particularly LDI, duration management, and spread analysis. Candidates who build a strong Level 2 Fixed Income foundation find Level 3 significantly more manageable. Practice with our Level 2 mock exams, where Fixed Income questions are broken down to the specific sub-topic level so you can identify exactly which of these four areas needs the most attention before your exam date.