of 98
The effective convexity of a bond is most likely to be negative if the bond is:
A) callable.
B) putable.
C) option-free.
Explanation
The effective convexity of a callable bond be negative (meaning that the upside for the
callable bond is smaller than the downside) when the call option is near the money.
Option-free bonds exhibit positive convexity, meaning that the price rises more when
interest rates fall than the bond price declines when interest rates rise by the same
amount. The convexity of putable bonds is always positive.
(Module 27.6, LOS 27.l)
Bill Woods, CFA, is a portfolio manager for Matrix Securities Fund, a closed-end bond fund that invests in U.S. Treasuries, mortgage-backed
securities (MBS), asset-backed securities (ABS), and MBS derivatives. The fund has assets of approximately $400 million, has a current stock
price of $14.50 and a net asset value (NAV) of $16.00. Woods is a member of a four person investment team that is responsible for all
aspects of managing the portfolio, including interest rate forecasting, performing basic financial analysis and valuation of the portfolio, and
selecting appropriate investments for Matrix. His expertise is in the analysis and valuation of MBS and ABS.
The fund pays a $0.12 monthly dividend that is paid from current income. The basic operating strategy of Matrix is to leverage its capital by
investing in fixed income securities, and then financing those assets through repurchase agreements. Matrix then earns the spread
between the net coupon of the underlying assets and the cost to finance the asset. Therefore, when evaluating a security for investment, it
is critical that Matrix can be reasonably assured that it will earn a positive spread.
During the course of his analysis, Woods utilizes several methodologies to evaluate current portfolio holdings and potential investments.
Valuation methods he uses include nominal spreads, Z-spreads, and option-adjusted spreads (OAS). There is ongoing debate among the
investment team as to the merits and shortcomings of each of the methods. Woods believes that the OAS method is by far a superior tool
in all circumstances, while his fellow portfolio manager, Yuri Ackerman, feels that each of the methods can at times serve a useful purpose.
Wood and Ackerman's current discussion involves two similar FNMA adjustable-rate mortgage (ARM) securities Wood is considering
purchasing. Both ARM "A" and ARM "B" are indexed off of 6-month LIBOR, are new production, and have similar net coupons.
Select Financial Information:
ARM
Net Coupon
WAM
Nominal
Spread
OAS (bps)
Z-spread (bps)
A
6.27%
360
81
98
135
B
6.41%
358
95
116
129
Woods recommends that Matrix purchase ARM "A" with the 6.27% net coupon. He has based his conclusion on the calculated OAS of the
securities, which he believes indicates that ARM "A" is the cheaper of the two securities. Ackerman disagrees with Woods, arguing that OAS
is only one component of any analysis, and that a buy or sell recommendation should not be made based upon the OAS spread alone.
Ackerman claims that other measures, such as one of the many duration measures and convexity, need to be incorporated into the
analysis. He points out that both ARMs have equal convexities, but ARM "A" has a duration of 7.2 years and ARM "B" has duration of 6.8
years. These characteristics will affect the expected return in any interest rate scenario. Woods admits that he had not considered the
differences in the bond's durations, and he acknowledges that others factors should be considered before a recommendation can be
made.