Convexity is a concept used to describe bond yeilds, as is therefore super-relevant to today’s informed investor. Convexity is a measure of the sensitivity of a bond’s duration to changes in interest rates, and is extremely important to understand in today’s low-interest rate environment.
Q. So today we have a real classic term from the bond world… and we’re discussing it because it’s becoming very relevant to investors right now.
A. It certainly is, and we’ll explain exactly why in a second. But first, “convexity” shows the relationship between a bond’s price and its yield as interest rates change.
Everybody understands that as the relationship of bond prices and yields: as interest rates fall, bond prices rise because the promise to pay the higher amount is worth more to an investor. And the opposite is true. But: when you graph that out, the relationship between price and yield as rates change is not linear.
Q. And here we have a chart that shows that. Instead of a straight line, its more of a curve… so it’s called “convexity” for the shape of that curve. But there are two different shaped curves here… one is a lot more convex than the other. Why?
A. This is why its so important for people to know about this now. Because the amount of convexity bonds have generally depend on their rate… the lower the rate, the less convexity. In the bond bull market, that really helped investors, because it meant a very direct relationship between falling rates and rising bond prices. Their bond portfolios really shot up in value as rates kept falling from low to even lower.
Q. So I can guess this is going…
A. Exactly. The reverse, of course, is also true. Given that new bonds are being issued with super low rates, they’ve got very little convexity. Therefore, the relationship between interest rate rises and the price of new bonds falling will be very direct and linear: as interest rates rise, their price is really going to get crushed… they’ll be much more damage than would be true if those bonds had a 6 or 8% coupon.
Q. So you could say that “convexity” has really helped bond investors until now, but if rates do start moving up, it will really hurt them.
A. Not only could I! I do. And there’s even more danger for investors in bond funds, because they don’t have the luxury of just waiting for maturity and collecting principal… their market value loss is a very real loss.