I got this question wrong from a Kaplan essay test, but I genuinely don’t understand their explanation… maybe someone can help.
Cooper suggests buying more callable bonds for the portfolio by stating, “Callable bonds can outperform non-callables after a bond bull market when interest rates start to increase. This is
due to their negative convexity.” State whether you agree or disagree with Cooper’s
statement and explain why.
Disagree: if interest rate rise, bonds with higher convexity will perform better, therefore callable bonds are not preferred in this scenario given their negative convexity
Agree: During a bull market, declining interest and negative convexity result in the duration of
callable bonds declining. That reduced duration is beneficial during a subsequent initial rise in
interest rates. The lower duration reduces the price decline as rates increase.