Which of the following bonds may have negative convexity:
A.Mortgage backed securities.
B.High yield bonds.
C.All of these choices are correct.
D.Callable bonds.
Answer:C
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 principal and increasing the interest rate risk that investors of MBS may incur.
Callable bonds are similar to MBS because of the possibility that the principal 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.
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