Syndicated columnist Chuck Jaffe says that last year's losses in bond funds shouldn't make an investor sell now.

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Lydia E. in Solvang, Calif., is at a loss over her bond funds, literally and figuratively.

She invested in municipal-bond funds last year, primarily because she was told they were a “safe investment.”

“Understandably,” she writes, “all funds and stocks have tanked, but I don’t fathom why our bonds have gone down. If bonds are backed by taxpayers who believe their money is earmarked for specific projects … and collected from our property taxes … and our state hasn’t gone bankrupt yet, then why have we lost money on these bond funds?”

Lydia’s question is actually remarkably common for bond-fund investors.

According to Lipper, the average single-state municipal bond fund has lost 5.16 percent of its value over the past 12 months, slightly better than the 5.42 percent loss experienced by the average short/intermediate investment-grade bond fund, the 5.78 percent decline of the average ultrashort obligation fund and miles ahead of the 20 percent and more losses posted by the typical high-yield or junk-bond fund.

Her question also comes from a common misperception, where an average investor expects to feel like they have bought a bond rather than a fund.

Invest in a bond and — so long as the issuer does not default — you can hold the paper to maturity and get your money back with the promised interest. Because you hold the bond with no plans to sell it, you ignore day-to-day fluctuations in the bond’s price; your eyes stay on the prize, which is how much you’ll have at maturity.

Bond funds, however, must end each day by “marking to market,” or setting its daily share price. Simply put, each of the fund’s holdings is valued as if it had to be sold when the market closed, so that the bond fund’s net asset value reflects each and every hiccup that the long-term bond buyer ignores.

Consider any number of investment issues seen in the bond market in the last year, from credit concerns, to fears over the accuracy and honesty of ratings agencies, to the viability of bond insurers and more, and each problem was a gut punch to bond funds.

Every new headline seemed to make news that would push the day-to-day value of bonds down further, even though the news was not full of defaults and the kind of problems that actually turn ordinary bond investments into nothing.

In fact, default worries will actually be on the rise this year, which is precisely why Lydia is wondering what to do next; she didn’t expect to lose money in a bond fund, and now she fears that credit concerns could create a situation where she should actually expect trouble that could make her bad situation worse.

“It was a tough year for bond funds last year, but it won’t be this year,” says Mary Ellen Stanek, co-manager of Baird Aggregate Bond fund.

“Quality is on sale. We’ve never seen these kinds of spreads and yield advances, with the kind of conviction in the recovery of the value. It’s an unusual time and the credit markets are reflecting that, but if someone can ride this out carefully, they will be rewarded.”

Copyright 2009, MarketWatch

Chuck Jaffe is a senior columnist at MarketWatch. He can be reached at cjaffe@marketwatch.com or Box 70, Cohasset, MA 02025-0070.