What does the term 'negative convexity' imply for a bondholder?

The term 'negative convexity' refers to a situation where a bond's price-yield relationship is characterized by the price increasing at a decreasing rate as interest rates decline and decreasing at an increasing rate as interest rates rise. This often occurs in bonds with embedded options, such as callable bonds, where the issuer has the option to call the bond before maturity.

When a bond exhibits negative convexity, it behaves unfavorably as rates change. Specifically, if interest rates rise, the bond's price drops more significantly compared to bonds with positive convexity. Conversely, if rates fall, the price appreciation of the bond is limited because of the call option, which may become more likely to be exercised by the issuer. Therefore, a bondholder faces a greater risk of price decline when interest rates increase and limited benefits when rates decrease, resulting in a net unfavorable impact on the bondholder's position.

This understanding highlights the nuances that bondholders must consider when dealing with bonds that present negative convexity, particularly in volatile interest rate environments.