Negative convexity
Asset-Backed Securities glossary · Collateral & Cash Flow Modeling
Definition
The property of MBS whereby price gains as rates fall are capped (because issuers prepay) and price losses as rates rise are amplified (because durations extend); a defining MBS risk.
Negative convexity in plain English
Normally, when interest rates fall, existing bonds become more valuable — you're holding an above-market interest rate, so your bond's price climbs. Mortgage bonds cheat you on this: when rates drop, homeowners refinance and pay off their old mortgages early, so you get your money back right when you'd most want to keep earning that higher rate — capping your gains. And when rates rise, people are in no hurry to pay off cheap mortgages, so you're stuck holding a below-market bond longer, deepening your losses. Negative convexity is that lopsided "heads you barely win, tails you lose more" deal, and it's the signature risk of mortgage bonds.
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