While stocks have made lots of money for lots of people, they've also helped many investors lose their shirts. Like so many things in life, the stock market offers risks and rewards in equal measure. Particularly risk-averse investors have always assumed they had one safe haven: bonds. But those who consider bonds completely safe for their money can be unpleasantly surprised.
Into the red
As one bond fund in particular has demonstrated, even fixed-income investors can suffer significant losses over the short term. According to The Boston Globe, State Street's (NYSE:STT) Limited Duration Bond Fund -- offered to the firm's institutional investors -- lost roughly 37% of its value during the first three weeks of August, and was down almost 42% year to date through Aug. 21. You might expect such losses from a natural-resources or emerging-markets fund, but short-term bonds? Worse yet, this State Street fund was designed as an "enhanced cash" product, thought to be only marginally more risky than a money market fund.
Although State Street didn't comment for the Globe's story, one can speculate that the fund's losses resulted from investments in subprime mortgage-related securities, a sector that has experienced a lot of turmoil in recent weeks. Some also believe that the fund was leveraged to between two and three times its original investment, magnifying any existing losses. Roughly two-thirds of the Limited Duration Fund's assets are required to be invested in investment-grade debt, but the recent subprime meltdown has strongly affected even higher-quality fixed-income investments.
No safety guarantee
While fixed-income investments are generally considered a safe place to park money, the State Street example shows that even supposedly high-quality, short-term bond instruments can suffer eye-popping losses if the planets align correctly. While most bond funds will never experience losses of the Limited Duration Fund's magnitude, investors should know that fixed-income investments are not immune to market downturns, especially over short time periods. And while bonds have lost money in only two of the past 30 years (as measured by the return of the Lehman Aggregate Bond Index), bonds still posted negative returns in 28 quarters within that span of time.
The most common way to lose money with bonds is to sell them for less than you bought them. This happens when interest rates rise, making bonds issued at a lower rate less attractive. For example, if your bond is paying interest of 5%, and rates rise to 6%, why would someone want to buy your 5% bond and get less in the way of interest payments? To unload your 5% bond, you'd have to sell it at a discount, thus losing money.
Of course, right now, the problems plaguing the subprime mortgage market have more to do with lenders overextending themselves. Increasing numbers of mortgages in this sector have fallen behind on payments, increased default rates, and generated losses for subprime lenders. And these housing woes have spread quickly, even affecting upstream firms that may not directly lend to the subprime market.
Staying the course
While it's possible to lose money in bonds, that's no reason to run away from the fixed-income world. Most investors, especially those with a shorter time horizon, should have a good chunk of their assets in bonds. As with equity investing, try not to focus too much on quarter-to-quarter returns; take a longer view instead. Bonds are still the best option out there for reducing volatility and protecting capital.
Most bond investors' best approach is to invest in a bond fund, rather than individual fixed-income securities. This way, you can get exposure to multiple segments of the bond market, such as Treasuries, mortgages, asset-based, and corporate bonds with a much smaller minimum investment. To keep costs down, you might want to consider a broad-market bond exchange-traded fund such as the iShares Lehman Aggregate Bond ETF (AMEX:AGG) or the Vanguard Total Bond Market ETF (AMEX:BND). Whether you choose a passive index fund or an actively managed bond fund, make sure you know how much of your fund is invested in more volatile areas such as the subprime market or high-yield bonds, since these are the areas that most frequently cause trouble for bond funds.
Time will tell whether or not State Street can recoup its losses on its Limited Duration Bond Fund. While the fund's losses have surely been unhappy for its investors, they remind us that at times, even the most "safe" of investments can run into trouble. Keep your expectations in check, and you'll stand a much better chance of not being unpleasantly surprised by the market.
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Fool contributor Amanda Kish lives in Rochester, N.Y., and does not own shares of any of the companies or funds mentioned herein. The Fool's disclosure policy always plays it safe.
