Why Bond Convexities May Differ
The price sensitivity to parallel changes in the term structure of interest rates is highest with a zero-coupon bond and lowest with an amortizing bond (where the payments are front-loaded). Although the amortizing bond and the zero-coupon bond have different sensitivities at the same maturity, if their final maturities differ so that they have identical bond durations they will have identical sensitivities. That is, their prices will be affected equally by small, first-order, (and parallel) yield curve shifts. They will, however, start to change by different amounts with each further incremental parallel rate shift due to their differing payment dates and amounts.
For two bonds with same par value, same coupon and same maturity, convexity may differ depending on at what point on the price yield curve they are located.
Suppose both of them have at present the same price yield (p-y) combination; also you have to take into consideration the profile, rating, etc. of the issuers: let us suppose they are issued by different entities. Though both bonds have same p-y combination bond A may be located on a more elastic segment of the p-y curve compared to bond B. This means if yield increases further, price of bond A may fall drastically while price of bond B won’t change, i.e. bond B holders are expecting a price rise any moment and are therefore reluctant to sell it off, while bond A holders are expecting further price-fall and ready to dispose of it.
This means bond B has better rating than bond A.
So the higher the rating or credibility of the issuer the less the convexity and the less the gain from risk-return game or strategies; less convexity means less price-volatility or risk; less risk means less return.
Read more about this topic: Bond Convexity
Famous quotes containing the words bond and/or differ:
“Dont go on a mans bond in public, nor guarantee his debts in private.”
—Chinese proverb.
“Every family should extend First Amendment rights to all its members, but this freedom is particularly essential for our kids. Children must be able to say what they think, openly express their feelings, and ask for what they want and need if they are ever able to develop an integrated sense of self. They must be able to think their own thoughts, even if they differ from ours. They need to have the opportunity to ask us questions when they dont understand what we mean.”
—Stephanie Martson (20th century)