Convexity and prepayment risk

In a Nutshell

• Bonds, particularly longer duration bonds, demonstrate non-linear sensitivity between prices and changes in yields. This change in duration or interest rate sensitivity is most commonly referred to as convexity.
• While traditional non-callable fixed income securities such as US Treasuries demonstrate positive convexity, where the price sensitivity increases and yields fall and vice versa, callable bonds demonstrate negative convexity where price sensitivity to rising yields can increase.
• For fixed income investors who allocate to asset classes with issuer or borrower callability, negative convexity can compound price risks, as duration can extend simultaneously with rising yields, resulting in a larger negative effect on prices and returns.
• Elevated levels of interest rate or credit spread volatility can also amplify price risks around negatively convex bonds, as the empirical or implied risk of a larger move in yields—and corresponding decline in prices—is increased.
• Selloffs in both short-term and longer-term bond yields has resulted in elevated convexity risks around mortgages and other callable bond asset classes, with higher base level yields, elevated rate and spread volatility, and the potential for rates and spreads to become more positively correlated relative to the previous decade.

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