Convexity

Key Highlights

• Convexity is a way to measure how a bond’s price reacts to changes in interest rates, going beyond what duration can tell us.

• Types includes positive and negative convexity.

What is Convexity?

Convexity is a way to measure how a bond’s price reacts to changes in interest rates, going beyond what duration can tell us. It captures the “curviness” of the relationship between a bond’s price and its yield, showing how price changes aren’t always straightforward. Think of it as a tool that fine-tunes our understanding of a bond’s behavior when interest rates wiggle up or down.

Types of Convexity

• Positive Convexity: Most bonds have this. When yields drop, bond prices rise faster; when yields climb, prices fall more slowly. This is great for investors!

• Negative Convexity: Found in bonds with special features, like callable bonds or mortgage-backed securities. Here, price gains are limited when yields fall, and losses can be bigger when yields rise- not as investor-friendly.

Importance for Investors

• Risk Management: Convexity helps measure how much interest rate changes could affect a bond portfolio, making it easier to plan for risk.

• Price Volatility: Bonds with higher convexity (positive or negative) can see bigger price swings, which is key to understanding potential upsides or downsides.

• Portfolio Strategy: Knowing convexity helps investors build portfolios that either shield against rate changes or capitalize on them.