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.
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.
Area 2: Mortgage-Backed Securities — Prepayment Risk and Tranche Structures
Tells you exactly which sub-topics to study next — and in what order.
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.
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.
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.
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.