Convexity and bonds

Yesterday’s Globe and Mail included an interesting article by Boyd Erman on the impact of “convexity” on bond prices. That is, the measure of the sensitivity of the price of a bond to changes in interest rates.

As advisors, we try to avoid jargon like volatility, duration, correlation and tracking error. One investor friend of mine defines volatility this way: “it means the investment will drop in value as soon as I own it!” The term “convexity” is totally out of bounds and reserved only for bond specialists!

But Mr. Erman makes a valuable point in the article. Ignore all the discussion about the shape of the yield curve.  This is the key point – when bonds are only yielding 2%, a 1% increase in yields will result in a bigger drop in value when compared to a bond yielding 8%. So today’s investor has to be more acutely aware of the impact of rising interest rates on bonds in their portfolios.

Again, interest rates are not rising because of the prospect of inflation. They are simply starting down the path to “where they should be”. Current rates are at historically low levels to stimulate the economy. The need for these very low rates will decline as the economies stabilize.

The expected flight from bonds is plain to see – though tough to time precisely. Bond yields are up almost 0.25% in both Canada and the U.S (meaning bond prices have fallen).  And surprise, surprise, the stock markets are up. One of the reasons?  Individual investors shifted a total of $6.8 billion into U.S. stock mutual funds in the first 3 weeks of the year, much of it out of bonds. The result? The Dow Jones Industrial Average is up 6.5%, the S&P/TSX Composite Index is up 3% and the MSCI World Index is up 5.5%.