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Interest Rates Underscore the Inflation vs. Deflation Debate

An extension above the previous high in TLT will likely be fueled by deflationary pressures if we start to see a pullback in stocks, slowing economic data, or perhaps an escalation of geopolitical conflict. Conversely, we could see a break back below the 200-day moving average if inflationary pressures heat up, economic data blow past expectations, or tapering significantly reduces the underlying bid for treasuries.

I expect that we are going to see some additional volatility in equities this year as a reasonable outcome from the natural ebb and flow of the markets. That would also put pressure on junk bonds such as the iShares High Yield Corporate Bond ETF (HYG), which has been stretched to accommodate investors' willingness to trade interest rate risk for credit risk.

The yield on HYG is now below 5% as a function of capital appreciation and a wave of deflationary selling would likely send assets fleeing from this sector. I think that new money in high yield, senior floating rate notes, and convertible bonds is late to the party and may have trouble capturing the type of performance we saw last year. Picking your entry points carefully will be critical to success in navigating these overbought themes.

Beneficiaries of a flight to quality from these areas will most likely include investment grade corporate bonds, mortgages, and treasuries. The iShares Investment Grade Corporate Bond ETF (LQD) and iShares MBS ETF (MBB) are two areas to that will likely surge if we get a selloff in stocks or credit-sensitive securities. Both of these ETFs can act as a safety net, similar to TLT, when investors switch to a risk off mindset. However, it is important to keep in mind that higher credit quality and longer duration holdings are also more sensitive to swings in interest rates.

The bottom line is that you will have to tread a delicate balance in the fixed-income sleeve of your portfolio this year and be vigilant for numerous risks. The right mix of credit quality, duration, and sector exposure will be extremely important to avoid any potential pitfalls. In addition, the flexibility to shift in response to changing interest rate dynamics will play a big role in achieving a successful outcome no matter what is thrown your way.

At the time of publication the author had a position in HYG.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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