Convexity doesn’t matter if you can’t monetize it. That’s a bold statement, and I worry that the bond gods will smite me down for starting any sentence with “convexity doesn’t matter.” Since we are just past the holidays, I can’t help but use an analogy. Suppose you get a very nice sweater as a holiday gift, but it’s two sizes too large (congrats on getting healthy during Covid) and the company has a no return/exchange policy. In the end, what you have is something that is nice to look at, but can never be used (worn) or monetized (returned). So, let’s donate the sweater to a worthy cause and talk about municipal bonds and convexity, which is a win/win.
Convexity only matters if you can monetize it. Jake Remley does a great job of highlighting convexity’s virtues here. Jake’s comments may be best considered in the context of thinking about an Aggregate strategy, where duration adjustments can be made with nearly zero transaction costs due the liquidity and availability of Treasuries. Mortgage pass-throughs also have exceptional liquidity (second only to Treasuries), which can aid in the ability to monetize with minimal transaction costs. But what if you are operating in a market where convexity advantages only materialize when liquidity is thinnest? In such a single-asset class market, you would experience a pop in relative performance versus the index. But if liquidity is not present in order to lock in the newly achieved performance differential, you would watch that “alpha” wither away either long-term through the new yield headwind; in the short-run if yields and prices revert; or through elevated transaction costs if attempting to trade the asset class during illiquid times. Convexity-related performance “alpha” must be locked in. The beauty of a duration-neutral approach with a convexity advantage in a portfolio that holds Treasuries or potentially uncorrelated liquidity is that it can be monetized. Convexity that cannot be monetized is a yield headwind. You are paying for something (paying a higher price via accepting a lower yield) that cannot be used.
What do we mean by monetizing convexity-related alpha? If we stick with the municipal market, which is nearly 70% callable, convexity-driven duration moves can be material. For example, assume we enter into a rising rate environment. The call option becomes less in-the-money, and therefore the market/index begins to extend in duration. If the portfolio has a convexity advantage, it will extend less and better maintain its value versus the index. If duration neutrality was present at the beginning of this extension, we could sell the short-end of the portfolio, where value was retained the most, and buy longer securities at the new higher rates to fund the extension buys to meet the new longer index duration. The key to executing this trade is sufficient portfolio liquidity, which will be most present in a diversified portfolio.
When we discuss our crossover strategy, we also often mention the convexity advantage – the reason liquidity in one sector can wax, while in another sector it wanes. So, if we experience a bout of volatility pressuring municipal rates higher, which often simultaneously pressures municipal liquidity, we can sell front-end Treasuries, corporates, or securitized to fund and lock in the convexity alpha. Odds are greatly increased that sufficient cheap liquidity exists in the portfolio when more than one asset class is present.
One could argue that convexity might be the most overlooked benefit of diversification. When discussing diversification, fixed income investors are typically addressing price volatility, insurance against defaults, and to a lesser (although exceptionally important) extent, liquidity. But as we note earlier, convexity sans liquidity has minimal merit, and liquidity can be sacrificed without diversification. Putting this together means that diversification is a key ingredient in convexity alpha. I guess you could say that while convexity is the second derivative of duration, it is also a secondary benefit of diversification.
So, the next time a fixed income manager is commenting on their convexity advantage, ask how they monetize it. Part of the answer must involve liquidity and diversification. And the next time your grandmother wants to buy you a nice sweater, if she doesn’t ask, tell her you are a size medium. Hope you all had happy holidays.
