Our clients often ask me to join their board or ALCO meetings to discuss their latest A/L BENCHMARKS reports. “Nothing to heavy,” they say, “most of these folks aren’t really financial types.” It’s the same story at almost every one of our banks. Not that it’s a problem, it’s just that sometimes I have to explain some pretty in-depth concepts to these “non-financial” types and sometimes it’s difficult. You can get to “deer in the headlights” pretty quick if you start throwing around terms like duration, elasticity, and negative convexity. All too often I’ve seen other consultants, analysts, and “bond-guys” toss these terms around like everyone knows what they’re talking about.
Negative convexity is one such term that will really quiet the conversation. And it really shouldn’t - because most bankers (even the non-financial types) already know what it means.
Let’s suppose you have a loan portfolio of fixed-rate residential mortgages. You know that given a stable economy this portfolio will tend to be a longer-term portfolio with loans staying on the books for 5-10 years. You also know that, if rates fall significantly enough, more customers will tend to refinance or payoff these loans early. If these loans start to payoff sooner than 5-10 years, the overall life (sometimes called duration) of the portfolio will be shorter-term.
This can certainly be a down-side for a portfolio like this. If rates fall the bank could really benefit by keeping these loans on the books at higher rates. If they didn’t payoff early they could substantially appreciate in value. However, if a significant number of these loans do payoff early the bank won’t see as much appreciation. This is usually what happens.
On the other hand, if rates rise significantly enough, the opposite will happen. Fewer customers tend to payoff early when rates rise. If fewer customers payoff early, the loan portfolio will have a longer overall life (or duration). As rates rise these loans lose value or depreciate. And with fewer customers paying off early, the problem could get worse (if rates rise rise enough.) This is another potential down-side.
A portfolio like this is said to have “negative convexity”. It’s not generally a behavior you activity seek out, it’s more a side effect of having a loan portfolio (especially a fixed-rate portfolio).
Besides your loan portfolios, there are some other asset types that exhibit this type of behavior. Mortgage backed securities (MBS) for one, which really shouldn’t be a secret. An MBS is just a pool (or portfolio) of loans.
Another type is a callable bond. In a base stable environment, or in a rising rate environment the issuer isn’t likely to call the bond which means I have a longer-term investment. However is rates fall significantly enough, the issuer will probably call the bond turning my great high-yielding, long-term investment into a shorter-term one. Basically, in a lower rate environment, my money is refunded and I have to reinvest it in something else at a lower rate.
If it helps, here’s a bit more technical definition:
negative convexity. A type of convexity in which duration falls as rates decline and increases as rates rise. This is an undesirable property for a bondholder. When interest rates decline, the price appreciation slows. When interest rates rise, the price declines get increasingly larger. Negative convexity is caused by short-option positions.
Source: “Asset/Liability Management Basics for Community Financial Institutions”, by Jim Wilkinson.
(Note to the real data heads and analysts that might read this post. Please don’t contact me and tell me that my definition of duration, or convexity isn’t technically correct…I don’t care. On a daily basis I’m trying to educate senior bank management and board members of community banks about these concepts. I’m not teaching them to become CFAs.)