Sinking funds have negative convexity as is my understanding. If this is the case, why in the curriculum does it say “the price of these sinking fund structures did not fall as much compared to callables and bullets when interest rates rose”? (Level III Volume 4 Fixed Income and Equity Portfolio Management , 4th Edition. Pearson Learning Solutions 82). Callables I can understand but why wouldn’t they fall as much as bullets, which have positive convexity?
It will have positive convexity when rates rise it will be bought on par .
i would think b/c with a sinking fund, you’re retiring part of the debt periodically. so instead of the full amount of the bonds falling like a bullet or a callable where as interest rates rise that call options is worth less and less, here you are going to retire some of the bond periodically regardless, so probably the impact here is going to be less.
When rates rise, with sinking fund bond you can reinvest the cashflows at high rates, so this somewhat compensates for the falling price, therefore the price doesn’t fall as much. Someone please clarify this!
These discounted sinking funds retained price upside during interest rate rallies (provided the indicated bond price remained below par), and, given the issuers’ requirement to retire at least annually some portion of the issue at par, the price of these sinking fund structures did not fall as much compared to callables and bullets when interest rates rose. (Level III Volume 4 Fixed Income and Equity Portfolio Management , 4th Edition. Pearson Learning Solutions 82).
so to sum this up if interest rates fall zero coupons will outperform everything else due to positive convexity…(and callable and MBS will have -ve convexity so will increase less due to the rise in the call option and rise in prepayments)what happens here with putables?they overperform everything except zero coupons? if interest rates rise zero coupons will underperform everything?? which is the best to hold?putables,MBS,callables or sinking funds?
Putables, you can put the bond back at par or whatever the put price is and reinvest at a higher rate.
I think I figured it out. Sinking fund structures experience negative convexity when they are priced above par, but when priced below par they experience positive convexity. This would be because the issuer is obliged to pay back part of the principal at par, so this would benefit the holder when the price is at a discount to par. In other words, the sub-par bond holder would receive par for part of his bonds, making them more valuable (i.e. supporting the price). Convexity must turn negative above par for the same reason.