Convexity is generally considered a desirable trait. Bonds with greater curvature gain more in price when yields fall than they lose when yields rise. For example in Figure 16.6 bonds A and B have the same duration at the initial yield. The plots of their proportional price changes as a function of interest-rate changes are tangent, meaning that their sensitivities to changes in yields at that point are equal. However, bond A is more convex than bond B. It enjoys greater price increases and smaller price decreases when interest rates fluctuate by larger amounts. If interest rates are volatile, this is an attractive asymmetry that increases the expected return on the bond, since bond A will benefit more from rate decreases and suffer less from rate increases. Of course, if convexity is desirable, it will not be available for free: investors will have to pay more and accept lower yields on bonds with greater convexity.
CHAPTER 16 Managing Bond Portfolios
Figure 16.7 Price-yield curve for a callable bond.
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