With the recent significant rise in interest rates we are getting a lot of inquires about bonds. Many clients utilize bonds as a diverisfyer to stocks. Some clients are interested in the income they provide. Traditionally bonds are less risky than stocks. However, like all investments, fixed income portfolios are subject to various risks, including interest rate risk.
Interest rate risk refers to the risk that changes in interest rates will impact the value of the fixed income portfolio. When interest rates rise, the value of existing fixed income securities decreases, as investors can now purchase new securities with higher yields. Conversely, when interest rates fall, the value of existing fixed income securities increases, as investors must pay a premium to obtain higher yields elsewhere.
To measure interest rate risk on fixed income portfolios, investors often use the concept of convexity. Convexity measures the curvature of the relationship between a bond's price and its yield. As bond prices and yields are inversely related, changes in interest rates affect bond prices in a convex manner.
Convexity is a measure of the second derivative of the bond price-yield relationship, and can be used to estimate the change in bond prices given a change in interest rates. Specifically, the greater the convexity of a bond, the less sensitive it is to changes in interest rates.
Investors can use this information to manage interest rate risk on their fixed income portfolios. For example, if an investor has a portfolio with low convexity bonds, they may want to consider selling some of those bonds and purchasing higher convexity bonds to reduce the overall interest rate risk of their portfolio.
In conclusion, convexity is a valuable tool for investors looking to measure and manage interest rate risk on fixed income portfolios. By understanding the relationship between bond prices and yields, investors can make informed decisions about which bonds to include in their portfolios and how to balance their exposure to interest rate risk.