Think Positive…Positive convexity!
2nd May 2016
Both France and Belgium have issued 50-year government bonds in the past few weeks.
Why would anybody in their sane mind buy a 50-year bond with a 1.75% and 2.15% coupon respectively?
Simply explained: A bond with turbo chargers and airbags!
Given the low growth and global disinflationary environment…A 50-year bond can provide a portfolio with both a built-in turbo charger if yields fall, and an airbag in case you are wrong… for free! How can you not like this?!?!
Question: What is the duration or price risk of a 50-year bond?
Answer: 30…Meaning the price would rise 30% if the yield of this bond fell 1%…And vice versa.
Question: Which bond (same maturities) will outperform in a declining yield or rising bond price scenario?
Bond A: Coupon 1% or Bond B: Coupon 3%
Answer: Bond A because a lower coupon increases the convexity – i.e. boosts the turbo charger – due to the discounting of cash flows, as a lower coupon increases the duration of a bond ceteris paribus.
Positive convexity simply explained:
Source: AllianzGI, as of April 2016
For illustrative purposes only
Investment Implications: A free option
Low coupon and high duration bonds can benefit a bond portfolio during phases of extreme movements in yields. A bond with a very long duration with a low coupon provides an investor with two features for free…
1. Accelerating rising prices (a bond future will not increase at an accelerating price)
2. A decelerating falling bond price if yields rise in an extreme scenario
Who may be interested in these long duration, low coupon bonds?
1. Insurance companies and pension fund managers who have long-dated future payment liabilities…These are the natural end investors.
2. Bond portfolio managers who want to protect – especially against a sudden decline in yields…As these bonds will outperform long-dated bond futures as yield curves flatten and convexity works its “magic”.
This is not a recommendation or solicitation to buy or sell any particular security.
Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors might not get back the full amount invested.
Past performance is not a reliable indicator of future results. If the currency in which the past performance is displayed differs from the currency of the country in which the investor resides, then the investor should be aware that due to the exchange rate fluctuations the performance shown may be higher or lower if converted into the investor’s local currency.
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