Junk bonds in your portfolio: What to do

These are tumultuous times in the junk bond market.

Lucidus, a London–based high-yield credit fund, on Monday said it had liquidated its entire portfolio, following on the heels of decisions by two other high-yield funds, Third Avenue Focused Credit Fund and one at a hedge fund managed by Stone Lion Capital Partners, to suspend redemptions.

Meanwhile, returns on high-yield bonds are on track to be negative for 2015, in no small part because of the ailing energy sector. As of Friday, the Barclays U.S. Corporate High Yield Index was down 3.53 percent for the trailing 12 months, potentially making this the first down year since 2008.

All the action is leaving individual investors wondering what to do with their own high-yield bond exposure, particularly with an anticipated interest rate hike in the offing that could cause its own market reaction.

The advice from many financial planners is simple: Don't panic.

Investors "should stick with the appropriate plans they have in place. If they don't have a plan, now is the time to get one," said Stuart Ritter, senior financial planner and vice president at T. Rowe Price.

It also may not be a bad idea to use an online fund analysis tool to look at what your bond funds and target date funds own to get a feel for the true size of your high-yield bond exposure, he said.

"That gives people better insight into what their holdings are," he said, and probably "can comfort them that whatever that holding is, it's actually a small percentage of their overall portfolio."

For example, T. Rowe Price's standard model portfolio has 10 percent of an investor's total fixed-income exposure in high-yield bonds, Ritter said. That means investors with a 20 percent fixed-income allocation would have 2 percent of their overall assets in high-yield bonds, and whatever happened in that sector "would have a fairly muted impact."

Pamela Sandy, CEO and founder of Confiance, a financial advisory firm, is more guarded. She used to have a high-yield bond ETF in her model portfolio, but no more, she said.

Alluding to the prospect of an imminent rate hike, she said, "my clients have been out of that sector for a while just in preparation for whatever is going to happen with the Fed."

Sandy said individual investors' presence in the high-yield bond market has been rising, with low-interest rates inducing them reach for yield. But "I do think it's an area for higher risk for return than someone needs to take right now," she said.

"It's a good time to reassess and ask yourself if that's a level of risk you are willing to assume," she added. "Just because we like to be diversified doesn't mean you have to own every asset class at every time."

Certainly, defaults on high-yield bonds have been rising. The trailing 12-month default rate on high-yield bonds was 2.3 percent in the third quarter, up from 1.97 percent as of the middle of the year, according to the NYU Stern Salomon Center for the Study of Financial Institutions, which expects the rate as of Sept. 30, 2016, to reach 4.3 percent.

Senior couple concerned
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The problem is, when worries about defaults and higher interest rates sap confidence, a relatively illiquid market like the one for high-yield bonds can feel an outsize effect, since prices tend to swing more.

"When you get a stampede, everybody gets hammered, and we are now having a stampede," said David Mendels, director of planning at Creative Financial Concepts.

But Mendels urged investors not to panic. "These things do pass in waves," he said.

There are some investors who might consider selling their high-yield holdings, he said. "If they held them for the wrong reason, for example this pays a higher yield and therefore I like it better, they may want to get out," he said.

But Mendels said he personally has high-yield bond exposure "for strategic reasons, not because I'm anticipating the next upturn or downturn." And he does not intend to bail.

"I know of no better way to lose money," he said, "than market timing."