Key Takeaways
- Price gains smaller than losses for yield changes.
- Caused by embedded options like callable features.
- Increases interest rate risk and limits upside.
- Common in mortgage-backed and callable bonds.
What is Negative Convexity?
Negative convexity is a bond characteristic where price increases are smaller than price decreases for the same change in yield, typically caused by embedded options like issuer call features. This phenomenon results in a price-yield curve that bends downward, limiting upside potential while exposing you to greater downside risk.
Unlike positive convexity, which benefits investors as rates fluctuate, negative convexity means the bond's duration behaves asymmetrically, often extending as yields rise and shortening as yields fall. This concept is closely related to Macaulay duration, which measures interest rate sensitivity linearly but does not capture this curvature.
Key Characteristics
Negative convexity has distinct features that impact your bond investments:
- Embedded Options: Bonds with call provisions, such as callable bonds, are common sources of negative convexity due to issuer rights to redeem early.
- Asymmetric Price Movement: Price drops exceed price gains for equal interest rate changes, increasing risk during rising rate environments.
- Duration Behavior: Duration increases as yields rise and decreases as yields fall, amplifying losses and limiting gains.
- Common in MBS and Munis: Mortgage-backed securities and many municipal bonds often display negative convexity due to prepayment and call features.
- Impact on Yield Curve: The par yield curve shape can influence how negative convexity manifests in bond pricing.
How It Works
Negative convexity results from the interaction between bond price, yield changes, and embedded options. When interest rates fall, issuers may exercise an early exercise option like a call, limiting your bond's price appreciation because the bond is redeemed at or near par.
Conversely, when yields rise, the bond's duration lengthens, causing price declines to accelerate beyond what duration alone predicts. This asymmetry means that your bond portfolio could suffer amplified losses in rising rate environments while gains are capped when rates decline.
Examples and Use Cases
Negative convexity is prevalent in several fixed income sectors and has practical implications for your portfolio:
- Mortgage-Backed Securities (MBS): Prepayment risk causes duration to shorten when rates fall and extend when rates rise, creating negative convexity effects.
- Callable Bonds: Many municipal bonds and corporate bonds include call features that introduce negative convexity, affecting expected returns.
- Bond ETFs: Investing in funds like best bond ETFs can help manage exposure to negative convexity by diversifying across securities.
- Corporate Issuers: Companies such as BND may offer bonds with embedded options, influencing their convexity profile.
Important Considerations
When managing fixed income portfolios, recognizing and accounting for negative convexity is essential to avoid unexpected losses during interest rate shifts. Bonds exhibiting this feature often require higher yields to compensate for increased risk, but they can still underperform in volatile markets.
Careful monitoring of duration and convexity, along with diversification through instruments like bond ETFs, can help mitigate some risks. Understanding negative convexity also informs your decision-making around reinvestment risk and timing of bond sales or calls.
Final Words
Negative convexity signals asymmetric price behavior that can increase downside risk while limiting upside gains. Assess your bond holdings for embedded options and consider running scenarios or consulting a professional to understand potential impacts on your portfolio.
Frequently Asked Questions
Negative convexity is a bond characteristic where the price increases are smaller than price decreases for equal changes in yield. This typically happens because of embedded options like call features that limit upside gains while exposing investors to greater downside risk.
Negative convexity usually arises from embedded options allowing early redemption, such as callable bonds or mortgage-backed securities. These features cause price gains to be capped when yields fall, while price drops can be larger when yields rise.
With negative convexity, bond duration extends as yields rise, amplifying price declines, and shortens as yields fall, limiting price gains. This means price decreases are more severe than price increases for the same interest rate changes.
Callable corporate bonds, mortgage-backed securities, and many municipal bonds often show negative convexity due to their embedded call or prepayment options. In contrast, non-callable bonds like U.S. Treasuries generally have positive convexity.
Investors face heightened interest rate risk because negative convexity causes bigger losses when rates rise and smaller gains when rates fall. Additionally, callable bonds carry reinvestment risk if called early, forcing investors to reinvest at lower rates.
A 10-year callable bond with a 5% coupon may be called when yields fall to 4%, capping price gains near the call price. But if yields rise to 6%, the bond’s duration extends, causing sharper price drops, illustrating the asymmetric price behavior of negative convexity.
Investors need to carefully manage interest rate risk and reinvestment risk when holding negatively convex bonds. Often, higher yields on these bonds compensate for the increased risk, but monitoring rate changes and bond features is essential.
