Why Bonds Are Falling so Fast

Over the past month, rates on 30-year Treasury bonds rose from 3.32%, to 3.54%,  an increase of only 0.22 percentage points. Yet, a 30-Year Treasury bond issued with a face value of $100 in May 2013 recently traded hands at $87.125 in late June. That's a huge swing on a pretty small move in rates. With the Federal Reserve indicating it will taper its bond-buying program as economic conditions improve, chances are very good that rates will continue to rise, and prices of existing bonds fall.

Because interest rates are so very low at the moment, small changes in interest rates drive huge swings in the market prices of existing bonds. It's the nature of the beast, and it's driven by something called the bond's modified duration. With rates so low and poised to rise, understanding why modified duration drives prices may be the most important thing bond investors can do right now to protect their capital -- and their sanity.

Why it works this way
Bond investors generally look to maximize the amount of income they get for a given amount of risk. Bonds are priced based on their debt ratings, time to maturity, possible tax advantages (like municipal bonds paying potentially tax free interest ), and features like whether the issuer can call them away early. Because there's a known schedule to their payments, and a known value to their most typical features, it's very straightforward to compare bonds to one another.

There are currently four U.S. companies with the top ranked AAA debt rating: Microsoft (NASDAQ: MSFT  ) , ExxonMobil (NYSE: XOM  ) , Johnson & Johnson (NYSE: JNJ  ) , and Automatic Data Processing (NASDAQ: ADP  ) . Investors buying their debt are nearly completely certain that they'll get all their interest payments on time, and get full redemption value when the bonds mature.

With the risk of not getting paid virtually eliminated, if all four of those companies were to offer bonds with similar terms, bond investors looking for AAA debt would flock to the one paying the highest rate. For the other bond issues to attract investors, they'd have to offer an equivalent total return to get their fair share of the investors' dollars. The modified duration calculation is simply the math that sets the prices of existing fixed-rate bonds in line with new ones issued with similar terms, given changes in rates.

How to reduce the impact of rising rates
The lower a bond's modified duration, the less its price moves as rates change. In a rising-rate environment, the price of a bond with a modified duration of 15 can fall a whopping 15% for a mere 1 percentage point increase in rates. On the flip side, if a bond had a modified duration of five, it would only fall 5% from that 1 percentage point rate hike. As rates rise, bond investors best protect themselves by being in the positions with the lowest modified duration that meet the rest of their investing criteria.

Unfortunately, there still ain't no such thing as a free lunch, especially in bond investing. There are trade-offs for every decision that lowers a bond's modified duration. The three key factors that drive modified durations and their trade-offs appear below:

Time to maturity: The less time before a bond matures, the lower its modified duration. The trade-off: Most of the time, shorter-term bonds have lower interest rates than longer-term bonds, so current interest payments will likely be lower. Coupon yield: The higher a bond's coupon yield, the lower its modified duration. The trade-off: Bond issuers don't offer high coupon rates on their bonds because they want to; they do it because they have to in order to attract investors to an issue at their particular risk level. Current yield to maturity: The higher a bond's current yield to maturity, the lower its modified duration. The trade-off: If a bond has an abnormally high current yield to maturity compared to bonds that otherwise appear similar, chances are it's because the market believes the issuer's credit quality has deteriorated.

It's not all bad news
Of course, while rising rates are very tough on currently existing bonds, they also mean that newly issued bonds carry higher coupon payments. As existing bonds mature, an investor rolling over the cash from those maturing bonds may be able to get more income from a new bond than from the old one it's replacing. It's just another trade-off that bond investors face in today's rising rate environment.

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