How do convexity trades work in fixed income?

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AcadiFi · Accepted Answer

Convexity measures the second-order sensitivity of bond price to yield changes. A bond with higher convexity gains more when yields fall AND loses less when yields rise, for the same duration. **Buying convexity** = structuring a position with higher convexity than the benchmark (duration-matched). Examples: barbell, long-duration zeros, callable bonds (from issuer perspective — they're short convexity; investor buys by avoiding callables), explicit options. **Selling convexity** = taking a position with lower convexity. Examples: bullets, MBS (prepayment risk = negative convexity), callable bonds from investor perspective. **When to buy convexity**: 1. Expect large volatility in rates (regardless of direction). 2. Upcoming Fed decision, election, or macro catalyst. 3. Current market-implied vol seems cheap relative to realized. **When to sell convexity**: 1. Expect low rate volatility (stable environment). 2. Need to earn yield pickup — convexity is expensive. 3. Funding a carry trade. **Cost of convexity**: Higher convexity typically means lower yield. The market prices convexity via the yield pickup forgone. On an MBS, for instance, you earn a spread over Treasuries partly BECAUSE you're short convexity (prepayments). Worked example: Halcyon Fixed Income Fund runs $200M duration-neutral trade. Sells $200M of 30-year Treasury STRIPS (very high convexity), buys $200M duration-matched in 10-year Treasury bullet. Net: short convexity. Yield pickup: ~18bps. If rates stay stable, fund earns 18bps × $200M = $360K annually. If rates drop 50bps, convexity loss may be −$800K. Break-even: low vol environment wins; high vol loses. ```mermaid graph TD A[Convexity Trade] --> B{Expect
rate vol?} B -->|High vol| C[BUY convexity
barbell / STRIPS] B -->|Low vol| D[SELL convexity
MBS / callables] C --> E[Pay yield
for gamma] D --> F[Earn yield
pickup] ```

How do convexity trades work in fixed income?

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