For most Australians, bonds are the bedrock of a balanced portfolio—a source of steady income and stability when share markets turn turbulent. But there’s a lesser-known risk lurking beneath the surface: negative convexity. In 2025, with Australian and global rates in flux, understanding this concept has never been more crucial for savvy investors.
What is Negative Convexity?
Convexity is a measure of how the price of a bond changes as interest rates move. Most traditional bonds have positive convexity: as rates fall, their prices rise at an increasing rate. Negative convexity flips this script—meaning the bond price doesn’t rise as much when rates drop, but falls more sharply when rates go up. This risk is especially pronounced in certain types of bonds, including callable securities and mortgage-backed instruments.
Common examples of negative convexity in Australia:
- Callable corporate bonds: Companies can redeem these bonds early if interest rates drop, capping your upside.
- Mortgage-backed securities (MBS): As rates fall, homeowners refinance, causing early repayments and limiting price gains for investors.
Why Negative Convexity Matters in 2025
The RBA’s rate policy has been anything but predictable, and 2025 looks set to continue the trend. With rate cuts on the table to spur economic growth, many investors are flocking to fixed income, hoping for capital gains as yields fall. But negative convexity can spoil this strategy. Here’s how:
- Limited price appreciation: When rates drop, callable bonds may be redeemed, so you miss out on the full price rally.
- Reinvestment risk: If your bond is called or prepaid, you’re forced to reinvest at lower yields, reducing future income.
- Heightened price sensitivity: If rates rise, these bonds can fall in value faster than traditional bonds, compounding losses.
For example, in late 2024, several Australian listed property trusts issued callable notes. When the RBA signaled a dovish turn, many of these were redeemed, leaving investors scrambling to find comparable yields in a lower-rate environment.
Spotting and Managing Negative Convexity in Your Portfolio
Not all bonds are created equal. To safeguard your investments, it’s vital to identify which holdings carry negative convexity and adjust your strategy accordingly. Here’s how:
- Read the fine print: Examine whether your bonds are callable or have embedded options that allow early redemption.
- Diversify across structures: Mix traditional government and corporate bonds with those less prone to negative convexity, such as inflation-linked or step-up notes.
- Monitor interest rate trends: Stay alert to RBA announcements and global rate changes, as these influence the likelihood of calls and prepayments.
- Consider professional management: Some fixed-income funds actively manage convexity risk, adjusting exposures as conditions change.
It’s also worth noting that APRA’s 2025 regulatory updates now require fund managers to disclose convexity risk in retail bond funds, making it easier for investors to assess and compare their options.
The Bottom Line: Knowledge is Your Best Defence
Negative convexity isn’t just a technical quirk—it’s a real-world risk that can quietly erode your bond returns, especially as Australia’s interest rate cycle twists and turns. By understanding how it works and where it lurks, you’ll be better equipped to make informed, confident decisions about your fixed income portfolio.
