Can some body explain this to me- Negative convexity and high yield relation? Thanks Which of the following bonds may have negative convexity: A) Mortgage backed securities. B) All of these choices are correct. C) High yield bonds. D) Callable bonds.
D?
Only callable bonds have negative convexity.
But there is negative convexity in mortgage backed securities too, called prepayment risk. Not sure how high yield bonds (junk bonds, right?) would have negative convexity…
D I think. MBS can have neg convexity since there is prepayment risk similar to a callable bond. As for high bonds. Why couldn’t they? If they had options there would be great incentive to call them if the firm was upgraded.
juventurd, can you explain your answer about high yields and how can they have negative convexity. S
I’ll go with B). First, MBS are usually subject to prepayment risk which is just call risk. That means MBS and callable bonds both can have neg. convexity (remember that neg convexity only happens at yields where the bond is likely to be called; these bonds do not always have neg. conv.). Anyway, 2 choices correct pretty much means you need to go with B). High-yield doesn’t imply neg. conv. but in general the junkier a bond’s (initial) credit quality, the more likely it is to be callable. As juven points out, if you issue single B debt, there is huge incenive to make it callable because if either interest rates drop OR your credit quality improves you want to drop your cost of debt.
saurya, High yields will only have neg conv if there is a call option. If you have higher rates on your debt, you have more reason to put call options on it in case you get upgraded. The question says “may” have neg convexity. I interpret this as “most likely to”. I could be wrong. I believe high yields have a higher likelihood of having a call option than most other bonds. Do you have an official answer/rationale to this question from Schweser or wherever it’s from? Also, I meant B not D in my original post. That’s what studying on a friday night instead of drinking gets you.
I got this question last night to from the QBank. This is Schweser’s answer: “Negative convexity is the idea that as interest rates decrease they get to a certain point where the value of certain bonds (bonds with negative convexity) will start to increase in value at a decreasing rate. Interest rate risk is the risk of having to reinvest at rates that are lower than what an investor is currently receiving. Mortgage backed securities (MBS) may have negative convexity because when interest rates fall mortgage owners will refinance for lower rates, thus prepaying the outstanding principle and increasing the interest rate risk that investors of MBS may incur. Callable bonds are similar to MBS because of the possibility that the principle is being returned to the investor sooner than expected if the bond is called causing a higher level of interest rate risk. High yield bonds may exhibit negative convexity because they are lower quality bonds with large coupon payments thus causing a larger potential for interest rate risk when interest rates fall because the investor has to reinvest their cash flows at a lower interest rate which is similar to both MBS and callable bonds. High yield issuers would be more prone to refinancing their debt as interest rates fall since they pay an initially high rate of interest and would greatly benefit by refinancing.”
MT327 Wrote: ------------------------------------------------------- > Interest rate risk is the risk of having to > reinvest at rates that are lower than what an > investor is currently receiving. I believe this to be re-investment risk. Interest rate risk refers to the effect of changes in the market rate of interest on bond values. Struggling with this concept of negative convexity. Schweser also says that when approxmimating a bond’s percentage price change the convexity adjustment is always positive as (changey)^2 is positive. Not true given negative convexity. Can anyone add clarity?