Are there bonds with negative convexity
Negative Convexity Definition & Example | - 2021 - Financial Dictionary
What is it:
Negative convexity relates to the shape of a bond's yield curve and the extent to which a bond is. Price is sensitive to changes in interest rates.
How it works (example):
The degree to which a bond's price changes when interest rates change is known as duration and is often represented visually by a yield curve. Convexity describes how the duration of a bond changes when the interest rate changes. This means that investors can learn a lot not only from the direction of the yield curve, but also from the curviness of the yield curve. Accordingly, convexity helps investors anticipate what will happen to the price of a particular bond if market rates change.
In general, bond prices rise when interest rates fall. A bond with negative convexity loses value as interest rates fall. This is often the case with Mortgage-Backed Securities (MBS), as they are based on underlying mortgage loans that are typically refinanced (and thus prepaid) when interest rates fall. The early repayment penalty is due early, so investors reinvest their money at the current lower rates.
Why it matters:
Convexity is a price predictive tool for bonds. It also reveals a bond's interest rate risk and helps investors assess whether the return on a bond is worth the underlying risk.
Most mortgage bonds are negatively convex largely because they can be prepaid. Callable bonds can also have a negative convexity at certain prices and yields. This is because an issuer's incentive to call a bond at face value increases as interest rates decrease. In fact, the price might actually fall as it becomes more obvious that the bond is being called.
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