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Negative Convexity

Negative convexity refers to the phenomenon where a bond’s price decreases as interest rates rise. This occurs when the coupon rate of a bond is less than the interest rate of its time to maturity—in other words, when the bond pays a lower coupon rate than it could get elsewhere in the market. This phenomenon creates a concave yield curve, meaning that the yield of a bond changes at a slower rate as interest rates rise.

Negative convexity can create a number of risks for investors. For example, if interest rates rise, the price of the bonds may fall, resulting in a loss for the investor. This is made worse by the fact that the extent to which the bond’s price falls is more pronounced when interest rates rise. For example, a bond's price might decrease more when the interest rate rises by 1% than when it rises by 0.5%. This creates a greater risk for investors in terms of the potential for losses.

Negative convexity can also create risks for investors in terms of timing. When interest rates are low, investors might be less likely to purchase a bond with a lower coupon rate due to their higher cost. Conversely, when interest rates are high, investors might be less likely to purchase a bond with a higher coupon rate, again due to their high cost. This means that investors have to be aware of the potential timing risks that can arise when interest rates change.

Due to these potential risks, assessing and managing a portfolio's exposure to negative convexity is a critical task for all investors. By assessing the yield curve, investors can identify and neutralize any potential risks posed by negative convexity. This can be done through portfolio construction techniques and the use of hedging instruments.

The exact degree of exposure to negative convexity may vary from portfolio to portfolio, but the general principal remains the same: always be aware of how interest rate movements can affect your portfolio and strive to limit downside risk. By understanding and managing the risk of negative convexity, investors can better ensure the safety of their portfolios in any type of market.

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