- Private Equity
There are endless resources for standard coverage and M&A investment banking, but good lists of technical fixed income interview questions are hard to come by. Here's a curated list of questions and answers to help you prep for any entry-level fixed income interview across capital markets, levfin, credit investing, or corporate banking.
Question: What is modified duration?
Answer: Modified duration measures the sensitivity of a bond's price to changes in its yield-to-maturity, driven by market interest rates. It's essentially the linear relationship between prices and interest rates.
For example, a modified duration of 5 indicates that for every 1 percent increase in yield to maturity, the bond’s market value will decrease by 5 percent
Said another way, if interest rates rise by 5% and you have a 5 year duration, your bond price will fall by about 5%. Duration works best for small changes in interest rates.
Question: What is spread duration?
Answer: Spread duration is the sensitivity of a bond's price to changes in its credit spread. A security's credit spread is the difference between the yield-to-maturity of the security itself and the yield of a benchmark rate (treasury or other government bond).
Spread duration is equivalent to modified duration for all securities with the exception of Treasuries, which have a spread duration of 0.
Question: Explain the concept of convexity
Answer: The real relationship between rates and prices is not linear. Convexity tells you how curved the relationship is by measuring the change in duration for a given change in interest rate. It's a measurement of the the sensitivity of a given bond's duration to interest rates and is calculated as the second derivative of the bond's price with respect to its yield.
A bond with greater convexity is less affected by changes in interest rates than a bond with less convexity. In general, the higher the coupon rate, the lower the convexity of a bond. Zero-coupon bonds have the highest convexity.
A helpful Bloomberg chart outlining an example of convexity
Question: Which types of bonds would exhibit negative convexity?
Answer: Negative convexity occurs when a bond's price at the price of a bond falls as well as interest rates, resulting in a concave yield curve. Mortgage-backed securities are a good example of bonds with negative convexity. Their price will typically not rise as quickly, and may even drop, when market rates decline. This is because the underlying mortgages, such as individual homeowners, are likely to prepay and refinance at the new lower rates.
Question: What is a cross-default?
Answer: Some bond indentures will reference additional securities with cross-default language. If one of these other securities experiences an Event of Default, then the bond is also considered in default. For example, Homie Widgets Co. fails to pay a coupon on a set of 2024 notes, a separate set of 2026 notes with a cross-default provision will also be in default.
Question: What is an Equity Cure?
Answer: Equity cure provisions allow borrowers to make an equity contribution for the purpose of fixing a covenant violation, such as a maximum leverage test. These are most commonly found in PE-backed deals.
Question: What are Cov-Lite loans?
Answer: Cov-lite is shorthand for covenant lite. These are loans that have bond-like financial incurrence covenants instead of traditional term loan maintenance covenants. Maintenance covenants are substantially more restrictive for borrowers, so there is a strong preference for covenant lite. These have become increasingly popular in PE-backed deals.
Question: What are the two primary types of loan default?
Answer: The two primary types of loan default are technical defaults and payment defaults. Technical defaults occur when the issuer violates a provision of the loan agreement (covenant tests, for example). Payment defaults are much more serious and occur when the issuer misses either an interest or principal payment.
Question: What are the most important terms to review in an indenture?
Answer: A good answer will touch on a number of the following items – Amount (including both issued and outstanding), Coupon (including implied yield-to-worst [YTD] and yield-to-maturity [YTM]), Rank and Priority, Events of Default, Guarantors, Governing Law, Change of Control Put, and Incurrence Covenants.
Question: What is acceleration?
Answer: A security may include an acceleration covenant, which stipulates that the creditor may demand immediate repayment if certain conditions are not met by the borrower. These conditions could include missing payments, receiving a ratings downgrade, or any number of items specific to each indenture. Bonds may also include cross-acceleration language (similar to the earlier cross-default question).
Question: You have the option to purchase one of two high-yield bonds, each with identical coupons and maturities. One bond is issued by a supermarket chain and the other from a technology company. Which bond would you prefer to purchase and why?
Answer: You should first ask some clarifying questions. How much collateral is there? Even in a high-yield scenario, this is an important point to cover. The supermarket chain may have significant physical assets (real estate, trucks, distribution centers, etc.) while the technology company may not, giving the supermarket a higher liquidation value and substantially reduced credit risk. Confirm that assets are owned, not leased. From a cash flow perspective, there is greater risk over the life of the bond from a tech company in a cyclical industry, vs. the supermarket in a defensive industry.
It is important to caveat that each of the bonds' prices should reflect the inherent risk. Thus, it will be up to an investor's specific risk appetite. Nailing the first portion of the answer is the most important, but this point can help quickly demonstrate full knowledge.
Question: You have the option to purchase a government bond with ten years to maturity or a corporate bond with five years to maturity. Which do you purchase?
Answer: The corporate bond has default risk, while the government bond is considered default-free. However, The government bond's longer time to maturity results in higher interest rate risk. If rates go up your bond will have relatively low rates for a longer period of time, or you will be required to sell the bond at a discount should you choose to reinvest elsewhere. There is also an increased risk of inflation over the ten-year period vs. the five-year period. The answer is that it depends on the investor and their risk preferences, balancing interest rate risk vs. default risk.
Question: What is an affirmative covenant?
Answer: Affirmative covenants outline what a borrower must do to remain in compliance with the loan. For example, the borrower must pay interest, regularly report financials, maintain business insurance, pay taxes, etc. These are typically standard items across loans.
Question: What is a negative covenant?
Answer: Negative covenants are highly-negotiated, in contrast to affirmative covenants. They limit what a borrower is allowed to do. Restrictions may be placed on things such as M&A, new debt issuance, and asset sales. The covenants may include baskets on a case by case basis allowing limited capacity for specific actions.
Here are a few more fixed income interview questions to work through as you prepare. Answers aren't provided, but these are key concepts that are worth spending some time researching.
Question: What's the difference between Yield to Worst, Yield to Current, and Yield to Maturity? Explain why they're each important to understand.
Question: What drivers could cause credit spreads to change?
Question: Should you convert an in-the-money convertible bond before maturity? Why or why not?
Question: When evaluating a bond, how would your analysis differ when reviewing a revenue bond versus a general obligation bond?
This list of fixed income interview questions should be a good starting point to prep for any summer analyst or full-time analyst roles, and can be a good refresher for anyone just starting out. I'll continue to update the list and make it more comprehensive. Drop a comment if you've come across any good questions recently or can think of helpful additions.