For fixed income securities such as Treasuries and corporate bonds, duration is a good, relatively stable measure of their price sensitivity to changes in interest rates because they generally mature at a fixed time.
The majority of municipal bonds, however, can be “called”—or redeemed early by their issuers—typically at the 10-year mark for a bond with a 30-year nominal maturity. The probability of that call option being exercised can change a bond’s duration. Negative convexity is the measure of that change.
Here’s how it can impact bondholders: In a falling rate environment, a callable bond’s duration typically shortens, muting price gains for the investors holding them, because they are more likely to be called. And when rates are rising, as they have been since March 2022, a callable bond’s duration tends to lengthen, amplifying price declines as the prospect of calling the bond becomes less attractive.