Fixed income at CFA Level II is not a continuation of Level I. The concepts go deeper, the models get more complex, and the vignettes require you to apply frameworks rather than recall definitions.
Most candidates underestimate it early and then scramble to catch up. This article covers the areas the exam tests most heavily, and what you actually need to know for each.
The Term Structure of Interest Rates
This is the starting point for almost everything in Level II fixed income. You need to understand:
- The difference between spot rates, forward rates and par rates
- How to bootstrap a spot rate curve from par rates
- How forward rates are derived from spot rates, and what they imply about expectations
The exam will often give you a spot rate table and ask you to price a bond, calculate a forward rate, or assess whether an arbitrage opportunity exists. These are mechanical once you know the framework, but they require precision.
Understand why a bond priced using spot rates must equal its price using the YTM, or you will lose marks on questions that seem straightforward.
Arbitrage-Free Valuation
This is where the exam moves beyond basic bond pricing. Arbitrage-free valuation uses a binomial interest rate tree to value bonds, including those with embedded options.
The key concepts:
- Constructing and calibrating a binomial tree
- Pricing a plain vanilla bond using the tree (it must match the market price — that is the "arbitrage-free" condition)
- Extending the tree to price callable and putable bonds
- Understanding the option-adjusted spread (OAS) and what it tells you
Callable and putable bond pricing trips up a lot of candidates because the logic of when the issuer or holder exercises the option is not always intuitive at first. Work through the tree mechanics slowly until the exercise logic becomes automatic.
Credit Risk and Credit Analysis
Level II introduces a more rigorous framework for thinking about credit risk than you saw at Level I.
The areas to focus on:
- Credit ratings versus credit spreads: what each measures and why they can diverge
- The four Cs framework and its limitations in practice
- Structural models versus reduced-form models for estimating default probability
- Credit default swaps: how they work, how they are priced, and how they are used
The structural versus reduced-form distinction is tested conceptually rather than computationally at Level II. Understand the intuition behind each: structural models treat default as an endogenous outcome of firm value; reduced-form models treat default as an exogenous event with a given intensity.
Mortgage-Backed Securities
MBS appear in most Level II fixed income vignettes in some form. The core areas:
- Prepayment risk: what drives it (refinancing incentives, seasoning, housing turnover) and how it affects cash flows
- The difference between pass-throughs, CMOs and stripped MBS (IO and PO strips)
- How rising versus falling interest rates affect prepayment behaviour and therefore value
- Contraction risk versus extension risk, and which tranches of a CMO bear each
IO and PO strips are a reliable exam topic. Remember: IO strips benefit from rising rates (slower prepayment, more interest paid) and are harmed by falling rates. PO strips are the opposite.
How to Prepare for Fixed Income Vignettes
A few things that make a real difference:
Know your formulas cold. Fixed income has more formulas than most other Level II topic areas. Spot rate calculations, bond pricing using trees, OAS, duration and convexity — these need to be automatic so you are not deriving them under exam conditions.
Draw the tree. When a vignette includes an interest rate tree, draw it out clearly before you start answering questions. Errors in tree-based questions almost always come from misreading the structure, not from misunderstanding the concept.
Watch the units. Semi-annual versus annual compounding, bond-equivalent versus effective yields — these details matter in fixed income calculations and the exam exploits them.
FinanceVault's CFA Level II Study Notes cover the full fixed income topic area with formula summaries, model frameworks and concept reviews designed around the vignette format.
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Written by a passed CFA Level II candidate. FinanceVault notes are built by candidates who know exactly where the exam focuses.