Definition of negative convexity

Bonds that typically lose value when interest rates fall, and vice versa, e.g, mortgage backed securities, are said to have negative convexity. [1]

Most bonds rise in value when interest rates fall, so that the yield they offer remains in line with the lower market rates.

But with mortgage-backed securities, a fall in interest rates brings the risk that borrowers will repay their loans to refinance at a lower rate.

As such, the value of these securities tends to drop when interest rates fall, a characteristic that is known as “negative convexity”.

In 2007, Colm Kelleher, chief financial officer of Morgan Stanley, said this was one reason why its bet on the subprime market went so badly wrong.  [2]

Morgan Stanley peers through looking glass

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