Investments should not be undertaken without adequate compensation for the downside risk. As fiduciaries we are lenders of our clients’ money. As such we endeavor to make prudent investments that have upside, but doesn’t unduly expose our client’s to the downside. Investors make decisions with incomplete information about the future. There is always a risk of uncertainty. How can fixed income investors navigate this risk of uncertainty? One of the factors we utilize to ensure we are compensated for risk is a bond’s credit convexity.
If interest rate convexity measures how the duration of a bond changes as the interest rate changes, then credit convexity shows how the spread duration of a bond changes as the credit spread changes.
To illustrate credit convexity a few graphs may be helpful. The first graph below shows how a non-callable security with a six year spread duration would act if credit spreads went up or down 100 basis points. With the starting price at par, the price increases 6% when spreads decrease 100 basis points. When credit spreads increase 100 basis points the price declines by 6% Compare this with a bond with negative credit convexity on the second graph shown below. This bond’s (two year call option and a six year spread duration) price would still decline 6% when spreads widen 100 basis points. But when spreads tighten 100 basis points the price increase will only be 2% instead of 6%. When spreads tighten this bond will be called and the issuer will reissue new bonds at lower spreads. This is an example of negative credit convexity.
Taking our example further, let’s look at how an investor can improve their negative credit convexity. One way to improve the unbalanced return profile is to invest in a seasoned bond with less spread duration. Below you can see that the solid line is less steep than the dotted line. Although the investor gives up some of the upside (can earn one percent instead of two percent if spreads tighten 100 basis points), the downside is half as much if spreads widen 100 basis points.
Another way to improve the unbalanced risk profile is to wait for a market event that leads to an entry point below par. If we now invest in this bond at a 94 dollar price we no longer experience negative convexity until the bond’s price returns to par. Just like in the original example the price would increase or decrease 6% when credit spreads tighten or widen by 100 basis points.
Regardless how confident investors are with their forecasts, bonds carry investment risks such as negative credit convexity. An investor needs to make sure they understand the risks, are getting paid for the risks and consider steps to mitigate those risks.