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This Could Be the Year Bonds Start to Deflate

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Like a balloon with a slow leak, bonds may lose altitude in 2013, lagging stocks and other asset classes as a long-term bull market starts to wane.

"I think rates will creep higher during the course of the year on the back of 'growth's okay, Europe's not going to fall apart, inflation's not going down anymore,'" said Bob Doll, chief equity strategist for Nuveen Asset Management. Interest rates move inversely to prices.

But first, the tenacity of investors will be tested when Congress takes on the debt ceiling debate, which is expected to be more contentious than the "fiscal cliff" drama.

That could drive investors into the relative safety of bonds, as lawmakers clash in February and March over the thorny issue of tax reform and entitlement spending cuts. (Read More: What the 'Cliff' Deal Means for Those Paying the AMT)

Stocks rallied and Treasury yields moved higher Wednesday, as investors favored risk assets following a late night vote by the House on a "fiscal cliff" fix.

The bill staved off the reversal of tax hikes for about 99 percent of taxpayers. The bill also stopped the advance of the alternative minimum tax, but reversed a two percent payroll tax cut for all taxpayers. The deal won strong backing in the Senate but was harshly criticized by House Republicans for not addressing spending reductions.

"I think the deal that was struck and voted upon is probably a bad deal for all parties, but I think more importantly it really puts front and center the negotiations around the debt ceiling and the spending side is going to be much more contentious," said Greg Peters, global head of cross asset strategies at Morgan Stanley. "I see that creating much more in the way of volatility. This is a relief rally, and getting taxes firmed up is not a negative."

"I think Republicans are disgruntled. I think Democrats are disgruntled. It seems like it's really setting up for a vicious, vicious battle," said Peters. (Read More: Why Many Investors Are Selling Today's Big Rally)

Stocks gained more than 2.5 percent Wednesday, with the S&P 500 finishing at 1,462. The 10-year yield rose to 1.84 percent, and many strategists expect yields to test or rise the 2 percent level. The 10-year yield a year ago, at the end of 2011, was at 1.87 percent, but strategists don't foresee a big move higher because of Fed asset purchase programs.

Strategists also don't expect a massive asset reallocation wave in the coming year but investors could start to make changes.

"I think it's a chicken and egg sort of thing," said Doll. "I don't think people are going to sell bonds to buy stocks or anything else until they lose money in their bonds. Rates have to move higher, people have to lose some money before they make changes." (Read More: Wealthy Breathe a Sigh of Relief Over 'Cliff' Deal)

He expects stocks to fare better than bonds in 2013. "I think they're going to be okay. We'll get okay earnings growth," he said. "…We'll get some more PE if the world continues to calm down. We could see another okay year again. I think stocks will outperform most other things."

Leon Cooperman of Omega Advisors also expects stocks to have a better year. "I think buying U.S. government bonds is like walking in front of a steamroller to pick up a dime," he said on "Fast Money Half-Time Report." (Read More: Cooperman's Top Stocks for 2013)

Peters said investment grade debt returns could be flat and high yield could be up just several percent.

"Basically high yield and S&P were even last year. I don't think this year that will be the case. I think spreads between equities and bonds will be much wider and bonds will struggle to have positive performance," he said.

The S&P 500 rose 13.4 percent in 2012, and saw a total return of about 15.2 percent. High yield corporate debt in that time returned 15 percent and investment grade corporates returned 10.2 percent, according to Citigroup's Yield book corporate bond indexes.

"Investment grade delivered more than three quarters of equities with vastly less volatility," said Ed Marrinan, co-head of market strategy at RBS , adding it's very unusual for high yield debt to compete with equity market returns. He said he is not yet advising investors to sell, and there are still plenty of reasons to hold corporate debt. "Our recommendation is not yet, but there are some who believe it is probably appropriate," he said.

"It's also true equities have rallied, and I'm not convinced that equities have rallied proportionately to the move we've seen in less risky asset classes," he said. "If you're (Fed Chairman) Ben Bernanke, you could say quantitative easing hasn't fully expressed itself in the value of equities yet, if you compare them to the performance of higher quality and safer bonds."

Marrinan said corporate debt should continue to be attractive, particularly as long as the Fed continues its easing policies and holds interest rates at record low levels. Once the debt ceiling battle is resolved, strategists also see an improving economy pushing rates higher even with the Fed on hold.

"The sensitivity of bond prices to rising interest rates is growing, as we narrow the yields and continue to increase the dollar prices of these underlying bonds. There is definitely a latent risk that interest rate sensitivity is increasing as we push this rally further," Marrinan said.

In the coming year, there will be challenges for the bond market. "It may be the process of letting some of the air out or a change in mind set," he said. "What's been a 30-year rally in risk free government bonds might be in the process of bottoming. This multi-decade cycle is currently coming to its conclusion. It's hard to point to a day, a month or a quarter, or even to a year. It's more likely it's near its bottom and the trajectory for yields in the next five years is higher."

Meanwhile, as investors loaded up on corporate debt, companies took advantage of record low yields with a record $1.2 trillion of corporate debt issues. The final IFR Markets tally for 2012 came in at $960.2 billion for investment grade, an increase of nearly 30 percent from 2011, according to Thomson Reuters IFR. IFR says it expects to see a decline of about 12 percent in investment grade issuance in 2013.

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

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