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Highlights
- Describes an asymmetrical bond price response to interest rate changes.
- Price falls more sharply with rate increases than it rises with rate drops.
- Common in mortgage-backed securities due to prepayment risks.
Negative convexity is a characteristic of certain bonds where the price does not respond to changes in interest rates in a linear or symmetrical way. Typically, bond prices rise when interest rates fall and decline when rates rise. However, in the case of negative convexity, the price appreciation for a drop in yields is smaller than the price depreciation for an equal rise in yields. This creates a curve in the bond's price-yield relationship that bends inward, indicating reduced gains and heightened losses as interest rates shift.
This phenomenon is particularly evident in bonds that have embedded options, such as callable bonds or mortgage-backed securities. For instance, with fixed-rate mortgage bonds, when interest rates fall, homeowners often refinance their mortgages. This leads to early repayments (prepayments), which return principal to investors sooner than expected, often when reinvestment opportunities are at lower rates. As a result, the bond’s potential to gain in value is limited despite falling interest rates.
Conversely, when interest rates rise, there is no incentive for borrowers to refinance, and the bond continues to pay its lower coupon rate. The bond's price then declines significantly, and investors have no way to accelerate repayment. This asymmetry—limited upside with falling rates and substantial downside with rising rates—is the hallmark of negative convexity.
Conclusion
Negative convexity highlights the risks of holding certain fixed-income securities in fluctuating interest rate environments. Investors need to understand this concept to manage exposure effectively, especially when dealing with mortgage-backed or callable bonds that are more susceptible to this kind of price behavior.
