At some point, the party is going to end: Interest rates are currently at unsustainably low levels -- levels not supported by natural supply and demand, but by the Federal Reserve's aggressive policies.
Higher rates are generally good for people looking to put new money to work in the bond market. But what about those already invested in bonds?
As Dan Caplinger recently pointed out here on DailyFinance, this is an extraordinarily risky time to be in the bond market. If you're holding onto bonds right now, when rates rise, the price of existing bonds will drop. And that, in turn, will knock out much -- if not all -- of the safety the bond buyers thought they were getting by buying them in the first place.
Just how far will prices fall?
While all standard, fixed-coupon bonds will fall when interest rates rise, each will fall a bit differently based on what's known as its modified duration. It's a formula, available in Microsoft Excel and online calculators like this one that figures out how many percentage points the price of a bond will drop for a one percentage point increase in interest rates.
The bigger the modified duration, the bigger the risk.
When $100 Is Only Worth $90.60
U.S. Treasury Bonds are a potent example of this danger in action. As of this writing, the longest-dated U.S. Treasury Bond matures in November 2042 -- nearly 30 years from now. When those were issued last November, interest rates were even lower than they are today. Those bonds have a coupon rate of 2.75 percent, but their current yield to maturity is closer to 3.25 percent.
A half point rise in rates may not seem like a very big deal, but those bonds have lost nearly 10 percent of their market value on that tiny move. What was issued as a bond with a $100 face value can be picked up in the market for about $90.60.
Oh sure, Uncle Sam still guarantees that investors will get back the full $100 -- in 2042 -- and $2.75 a year in interest payments while they wait. But that guarantee is cold comfort for those who've just seen the value of more than three years' worth of those interest payments vanish in just a few months on a mere half-point rise in rates.
Running the Numbers
Indeed, calculating the modified duration of investment grade bonds from well-known issuers, the numbers right now can be a bit scary. The table below shows the gory details:
Current Yield to Maturity
US Treasury Bonds
Kraft Foods (KRFT)
Data from ScotTrade bond center, as of March 10, 2013. Modified duration calculated by author.
That nearly 10 percent drop in Treasury Bond prices since November could get a lot worse if rates rise another 1 percent. Should such a rise occur, the value of those bonds could fall another 19.4 percent.
And it's not just restricted to government loans, either. As the table shows, even highly regarded corporate issuers can see double-digit drops in their long-term bond prices with just that same small move upwards in interest rates.
What You Can Do
If you're worried about rates rising and punishing your bond holdings, there are some things you can do to reduce the impact to your portfolio. That said, there's no such thing as a free lunch, so there are trade-offs to weigh with each strategy:
Trade to shorter-term bonds. The shorter the time to maturity, the lower the modified duration. The trade-off: Shorter-term bonds typically have lower current yields than their longer-term counterparts.
Seek out higher yields. The higher a bond's coupon yield and yield to maturity are, the lower its modified duration. The trade-off: Higher yield bonds are typically higher yielding because they're at greater risk of defaulting on their debt than lower yielding ones.
Prepare to hold until maturity. Holding a bond to maturity will get you both the face value of the bond and all the coupon payments along the way, so long as the issuer stays solvent. The big trade-offs: You might have a long time to wait before you're made whole. Also, once you are made whole, you might find that the bond's redemption value won't buy as much as it once did thanks to inflation.
In today's low interest rate environment, bonds are nowhere near as safe as they used to be. By calculating a bond's modified duration you can see just how risky they are, and you can figure out where you'd rather put your money other than a risky issue that was once considered a safe haven.
Motley Fool contributing writer Chuck Saletta owns shares of Microsoft. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway and Microsoft. Try any of our Foolish newsletter services free for 30 days.