Bond duration has been the most popular measure for many years for estimating how much a bond's price will change due to interest rate changes. For example, if you have a bond with a five-year duration, and interest rates rise by one per cent, your bond's market value should drop about five per cent.
Unfortunately, bond duration is only a small part of determining the relationship between bond prices and interest rates because it is only relevant to small changes in interest rates. Bond price and interest rate volatility do not follow a straight line, but rather form a curved line.
Positive vs Negative Convexity: How to Interpret Bond Curvature
Positive convexity is often associated with the majority of plain vanilla bonds. Positive convexity indicates that as rates decrease (a 1% drop), the value of the bond will increase at a higher rate than it would decrease if interest rates were to rise (a 1% increase). As stated previously, a 10-year U.S. Treasury bond has positive convexity; therefore, if interest rates fell by 1%, an investor would receive a 9% increase in the value of their bond, whereas if interest rates increased by 1%, the value of the bond would decline by only 8%, resulting in asymmetrical returns that favour the bondholder.
Negative convexity has the opposite effect of positive convexity. It typically can be found in mortgage-backed securities (MBS) and callable bonds. In this case, there is an embedded option that ultimately reduces the potential returns for investors of either asset type.
The Pitfalls of Negative Convexity: Risks in MBS and Callable Bonds
Negative convexity arises from perverse structural incentives inherent in first-position fixed-rate residential mortgages (such as MBS), whereby the mortgage issuer has the right (also called an option) to call or prepay the mortgage. Therefore, MBS will produce a cash flow for the investor in the event of refinancing. Consequently, when a borrower refinances at a lower interest rate, that borrower will often take advantage of this “free option” provided by the mortgage issuer to call and prepay the mortgage.
For example, a corporation may issue a twenty-year callable bond with a call provision of up to ten years; after five years, the corporation may call the bond and incur a cost of paying back the bondholder at the par value plus an additional sum for call premiums. The callable bondholder would have an appreciation of $150 in value per bond based on the bond's yield, which could earn as much as 6% because of falling interest rates.
Interest Rate Cycles and Convexity: How Bonds Respond
Rising rate environments: Duration hurts, and Convexity acts as a buffer. When the Federal Reserve raised Interest Rates in 2022-2023, the bonds with higher convexity were able to withstand damage from the rising Interest Rates much better than the duration indicated that they should. The curve was protective in that, as interest rates rose more quickly, prices for the bonds with a high level of convexity declined at a slower pace.
Bond convexity creates "shock absorbance". Think of how the suspension system of an automobile helps it to drive over the bumps in the road. An automobile with a good suspension system (high convexity) can handle the bumps in the road much better than an automobile without a good suspension system. The first bump hurts; subsequent bumps hurt less.
Conclusion:
The benefit an investor receives from potential volatility can be measured by bond convexity. With the uncertainty surrounding interest rates in 2026, investors must know the bond curve to determine how to profit from market volatility. The key takeaway of the bond curve is that bonds with positive convexity will provide greater profits while mitigating potential losses. Bonds with negative convexity will limit a trader's profits just as they need to see larger returns. The duration of a bond tells the investor only the minimum information about the bond but bond convexity will illustrate how the bond should react when the market becomes volatile.
Investors with long-term treasury bonds and/or those trading bond CFDs for the purpose of profiting from volatility can take advantage of the benefits of convexity when they trade. Convexity illustrates that, rather than just a hope to profit from interest rate changes, by using convexity, investors will be able to guarantee profits based on these changes.
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