Both of these strategies have been effective combatants for rising rates in 2013 as billions of dollars have shifted in this general direction. However, there are a host of perils other than rising rates that may become a reality if certain conditions are met.
With the shortening of duration, many investors have taken on more credit risk than historical norms. This has created what many describe as a bubble in high yield debt that has the potential to unwind if we start to see an economic slowdown or rush for the exits. A stumble in the stock market could trip up junk bonds and send money fleeing from equities and credit sensitive holdings.
Right now we are still in an uptrend with respect to high yield, bank loans, and convertible bonds which is why I am recommending you hold on to your exposure in these areas. However, I am closely monitoring these high yield sectors for signs of a reversal which would warrant moving a portion of capital back to more quality holdings such as the iShares Investment Grade Corporate Bond ETF (NYSEARCA:LQD) or the iShares MBS ETF (NYSEARCA:MBB). These ETFs, along with treasuries, would likely do well in a deflationary environment under the scenarios of a flight to quality.
Another correlation I am monitoring with respect to high yield is the divergence between U.S. high yield corporate debt and emerging market bonds of a similar credit quality. Consider that the iShares High Yield Corporate Bond ETF (NYSEARCA:HYG) is trading near all-time highs and has a comparable yield to the WisdomTree Emerging Market Corporate Bond ETF (NYSEARCA:EMCB). However, EMCB is still more than 5% off its high water mark. I expect that this divergence will eventually correct and we could see money flow into emerging markets as fixed-income investors find more value and diversification overseas next year.