Think Positive…Positive convexity!

Brian Tomlinson
Written by

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:

graph

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.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer companies at the time of publication. The data used is derived from various sources, and assumed to be correct and reliable, but it has not been independently verified; its accuracy or completeness is not guaranteed and no liability is assumed for any direct or consequential losses arising from its use, unless caused by gross negligence or wilful misconduct. The conditions of any underlying offer or contract that may have been, or will be, made or concluded, shall prevail.

This is a marketing communication issued by Allianz Global Investors GmbH, www.allianzgi.com, an investment company with limited liability, incorpo- rated in Germany, with its registered office at Bockenheimer Landstrasse 42-44, 60323 Frankfurt/M, registered with the local court Frankfurt/M under HRB 9340, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht (www.bafin.de). The information contained herein is confidential. The duplication, publication, or transmission of the contents, irrespective of the form, is not permitted.