Schweser Constructed Response Question:
B. 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.
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.
My response was: Disagree. Callable bonds can outperform non-callabes in a rising rate environment if the higher yield earned from holding callable bonds is higher than the yield on the same bond without the embedded call. However, this is not due to negative convexity. Negative convexity is always a negative to a bondholder, and will not cause them to outperform.
Essentially, all-else equal, callable bonds should not perform during rising rate environment explicitly due to negative convexity. I don’t know how we are supposed to assume that in this case the bond was held during the bull market, duration declined, and then that resulted in the callable bond outperforming… It seemed to me that the question was asking specifically whether or not negative convexity can cause bonds to outperform during rising rates, and that answer is a definitive NO.
Any help? Am I looking at this wrong?