Bond convexity is one of the measuring metrics or tools to manage the risk exposure of bonds and other fixed-income securities. Various factors can influence bonds, cash flows, and prices. Convexity helps estimate how the changes may occur and at what volume.
Explaining Bond Convexity
A bond’s price can drop or increase with fluctuations in the market rates. Bond duration records the sensitivity of a bond towards the changes, as in how much the bond prices move with the movements of the market rates and how it impacts the repayment time.
Convexity shows how the bond duration changes as and when the market rates hike or fall. To be more specific, bond convexity is the measurement of the change that occurred in the bond duration due to every 1% change of prevailing interest rates in the market.
What Does Bond Convexity Mean for Investors?
Theoretically, the bond’s sensitivity to changes in interest rates increases with increasing convexity. Extreme pierce fluctuations can be expected. Likewise, decreasing convexity indicates shrinking exposure to market changes. In any case, you can expect low market risk and convexity for bonds offering high coupon rates.
Types of Bond Convexity
Bond convexity shows the equation between bond prices and interest rates. It can be either positive or negative.
- Positive Bond Convexity: When the price decreases following a hike in the market rates, or vice versa, the bond has positive convexity. It is typical for most fixed-income bonds.
- Negative Bond Convexity: When the drop in the market rates does not result in increasing the price of the bond, negative convexity has occurred.
Convexity Measuring Risk
Risk exists in the investment market, and duration takes that into consideration. Convexity expands the same concept. Duration shows a linear relationship between market rates and bond prices, which is helpful but also limits the task of risk evaluation after a point. Convexity acknowledges the relationship between the said two factors is more curved than linear. A linear concept can show accurate data but may not show the complete extent of the changes lying in the curves. Convexity fills the gap and provides a more extensive measuring tool.
Convexity can become a crucial part of investment management. It can be the advantage of changing interest rates and avoiding the negative impacts on investment.
Wrapping Up!
Finding bonds with high interest rates and low credit risk is a good investment strategy. That said, interest risks and other market conditions are important to remember to ensure the best returns on investment. Fortunately, concepts like convexity are available, which makes risk evaluation easier and more convenient.
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FAQs About What is Bond Convexity?
1. Is higher bond convexity better?
Higher convexity means more sensitivity to interest rate changes. That means the bond price will increase if the market rate falls. But it also means that the price will drop if the market rates go up.
2. How to interpret bond convexity?
If the bond prices move in the opposite direction of the market rates, it has positive convexity. Negative convexity shows falling market rates do not necessarily result in increasing prices or vice versa.
3. What influences convexity?
Coupon rates of the bonds, maturity period, and current price can influence convexity.
