Most crash-wary investors have their focus squarely on the stock market. Yet there's a big correction going on in an asset class you might not expect: fixed income, especially long-term bonds.
You may think of bonds as a way to stabilize some of the fluctuations in your portfolio. In the past week, however, the bond market has reminded investors that it can stir up some trouble on its own. With yields soaring and the yield curve finally turning right side up, you should be prepared for some sizable losses on your bond holdings when your second-quarter statements come out.
Long-term bonds have been hit the hardest. The iShares Lehman 20+ ETF (AMEX: TLT ) , which is an exchange-traded fund that holds Treasuries maturing 20 to 30 years from now, lost as much as 3.5% of its value in just the past week. Bond mutual funds have also paid the price, with benchmarks like the Vanguard Long-Term Bond Index (FUND: VBLTX ) having dropped almost 3% in four straight trading sessions through Tuesday.
Higher rates ahead?
This is just the most dramatic part of an ongoing drop in bond prices that has been happening since last December. Long-term bond prices have fallen 8% to 10% since those highs in December, when investors were convinced that rate cuts from the Federal Reserve were imminent. Now, more market commentators are suggesting that the next move from the Fed may be to hike.
All of this is just more bad news for interest-sensitive sectors of the economy, such as mortgage lending and real estate. With the subprime lending crisis having forced lenders to tighten their credit standards, rising mortgage rates will price some potential buyers out of a home purchase, even if they have good credit. This in turn could force sellers to lower asking prices to make them more affordable for prospective buyers, exacerbating recent price declines. Rising rates are a nightmare for homebuilders like Toll Brothers (NYSE: TOL ) , Pulte (NYSE: PHM ) , and Centex (NYSE: CTX ) , which could face not only lower demand but also higher carrying costs for their inventory.
For investors with bond-heavy portfolios, especially retirees on limited incomes, falling bond prices will translate into considerable pain. It's a good reminder, however, that even the most conservative portfolios can benefit from diversification. Even if you need current income, bonds aren't the only way to get it. Dividend-paying stocks and real estate investment trusts are just a couple of the alternatives that provide steady income without the same level of interest rate risk that bonds have.
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For more information about bonds, check out the Fool's Bond Center.
Fool contributor Dan Caplinger owns some bonds, but he isn't too worried about interest rates. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy won't fall down on the job.