An institutional portfolio manager is considering two Canadian government bonds for a pension fund with a long-term liability structure. Bond A has a modified duration of 7.5 years and a convexity of 0.85, while Bond B has a modified duration of 7.2 years and a convexity of 1.10. If the manager anticipates a significant decrease in interest rates, which bond would likely offer a more favourable outcome due to its convexity?

Question: An institutional portfolio manager is considering two Canadian government bonds for a pension fund with a long-term liability structure. Bond A has a modified duration of 7.5 years and a convexity of 0.85, while Bond B has a modified duration of 7.2 years and a convexity of 1.10. If the manager anticipates a significant decrease in interest rates, which bond would likely offer a more favourable outcome due to its convexity?

Answer options:

• Bond A, because its lower convexity will mitigate price increases. ✅ Bond B, because its higher convexity will lead to a more substantial price increase when rates fall.
• Bond A, because its higher duration will lead to a larger price change regardless of convexity.
• Bond B, because its lower duration implies less interest rate risk.

Correct answer: Bond B, because its higher convexity will lead to a more substantial price increase when rates fall.

Explanation: Convexity is a measure of the curvature in the price-yield relationship. When interest rates fall, bonds with higher convexity will experience a larger price gain than predicted by duration alone, making Bond B more attractive in a declining rate environment.