Never Mind Yield Curves, What’s Negative Convexity?

As bond yields rise and fall past certain levels, there are episodes of highly technical yet increasingly familiar flows that can accelerate moves in either direction. Analysts and traders use terms like negative convexity and convexity hedging to explain a phenomenon that’s been compared to a “beast” in the market. The result can lead to market distortion that makes it tricky to interpret what bond markets are really saying. What does it all mean, and why does it matter?

To take on convexity, we need to first grasp what’s known as duration. As interest rates drop, bond prices will rise and vice versa. The extent of the move is typically larger for bonds with a longer time to maturity. That relationship is known as duration. The change in the price and interest rate, or yield, of a bond isn’t linear. If you chart it with prices on one axis and interest rates on the other, you end up with a line showing the curvature in the relationship -- convexity. The higher the convexity, the quicker prices will rise as interest rates fall, and the opposite is true.