SPTL - High-Quality Bonds: Why Elevated Convexity Favors Extending Duration

2023-11-11 02:45:00 ET

Summary

• Convexity in the Bloomberg U.S. Aggregate Index is at record-high levels, indicating potential gains in bond prices when interest rates fall.
• The recent sell-off in U.S. Treasury yields has increased the importance of understanding convexity for investors.
• Investors should consider increasing the duration of their fixed income exposure to take advantage of potential outsized gains when rates begin to fall.

Convexity conceptualizes bond prices’ upside and downside potential in response to interest rate movements. Today, convexity in the Bloomberg U.S. Aggregate Index is at record-high levels, which means that bond prices currently have more potential for gains when interest rates fall and are less exposed to losses if interest rates rise. With the Fed at or near the peak of its hiking cycle, investors should consider acting early by increasing the duration of their fixed income exposure to capitalize on the potential outsized gains when rates begin to fall.

Bloomberg U.S. Aggregate Index convexity 1999–present

The recent sell-off in U.S. Treasury yields has sent shockwaves through the market, with the 10-year yield crossing the 5% threshold for the first time since June 2007. For investors looking to capitalize on the sell-off but are wary of higher yields, the concept of convexity remains key.

Convexity measures the sensitivity of a bond's duration to changes in interest rates. In essence, it adjusts the bond’s total return either up or down after accounting for changes due to duration. Positive convexity signifies that the potential gain in price appreciation resulting from a drop in yields is more substantial than the price depreciation caused by an equivalent increase in yields.

At the end of October 2023, the price on the Bloomberg U.S. Aggregate stood at $84.77 per $100 of face value, significantly lower than the $99.14 recorded in June 2007. This disparity in prices has resulted in a record-high positive convexity in the Index. Consider that over the next 12 months, a mere 50 basis point drop in yields could translate to an 11% higher price appreciation on the U.S. Aggregate Index.

With the Federal Reserve pausing its rate hikes and yield levels hovering at pre-GFC highs, investors should be considering extending duration in high-quality fixed income. The benefits of acting early, thanks to the market’s record high convexity, seem to far outweigh the advantage of a wait-and-see approach in fixed income.

Disclosure

Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results and should not be relied upon to make an investment decision. Fixed?income investment options are subject to interest rate risk, and their value will decline as interest rates rise.

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