Free CFA Level III: Portfolio Management Credit Strategies Practice Questions

C is correct. Bottom-up credit analysis focuses on individual issuers: analyzing financial statements, business fundamentals, competitive position, and management quality to assess creditworthiness. The analyst then identifies bonds that are attractively priced relative to their credit risk, seeking to buy undervalued credit and avoid overvalued credit.
A is incorrect because starting with macroeconomic analysis describes a top-down approach.
A is incorrect because index replication without active selection describes passive management, not bottom-up credit analysis.

A is correct. Sector rotation in credit is a top-down strategy that adjusts the portfolio's allocation across different credit sectors (e.g., financials, industrials, utilities, consumer) based on relative value analysis and economic outlook. For example, overweighting financials when the banking sector is expected to benefit from rising interest rates, or overweighting utilities when seeking defensive positioning.
Choice C is incorrect because rotating between equity and fixed income is an asset allocation decision, not a credit sector rotation strategy.
Choice B is incorrect because maintaining constant sector weights is a passive approach, not sector rotation.

C is correct. The cash bond earns OAS = 175 bps over the risk-free rate as compensation for bearing the issuer's credit risk. Selling CDS protection on the same issuer earns the CDS spread of 165 bps per year. Both positions lose par value upon a credit event, but the cash bond compensates 10 bps more per year for the same credit exposure. This 10 bps positive basis (OAS > CDS spread) means the cash bond is the higher-yielding position for the same credit risk, making it economically superior under the stated assumptions. A is wrong because avoiding the upfront bond purchase cost is not an advantage if the manager is comparing returns on equal notional; the relevant comparison is yield/spread earned per unit of credit exposure, where the bond's 175 bps exceeds the CDS's 165 bps. B is wrong because the basis (OAS minus CDS spread) is not merely a transaction cost artifact; it can persist due to supply/demand technicals, funding constraints, and regulatory capital differences, and while the basis may narrow over time, a 10 bps persistent positive basis represents a genuine return advantage for the cash bond.