For all but the contrarians, uncertainty over a deficit-reduction deal and the economic recovery, combined with certainty about the Fed's liquidity efforts, will make the fixed-income market a familiar place in the year following a national election that preserved the status quo in Washington.
U.S. Treasurys, high quality corporate bonds and to a lesser extent select high-yield bonds are the investments of choice, even if their already unattractive — and in some cases unprofitable — yields budge a little bit in either direction, analysts say.
"What you see is what you get," said James Awad, managing director at Zephyr Management. "Slow growth, regardless of who's president; low inflation, for the time being; in Europe, a modest contraction; in emerging markets, a bottoming in the de-acceleration of growth; the U.S. deficit kicked down the road with maybe a modest package — some tax hikes, some spending cuts; and the Fed's liquidity. None of that will change the character of the fixed income market."
Not that those circumstances make fixed income investing any less challenging than it has been in the past two years, when interest rates defied almost everyone's expectations, hitting new lows.
"This is a very difficult environment because of the low rates and the potential risks," said Howard Kaplan, a financial planner in Tenafly, N.J. "When is safe money going to get some payment? I don't think anyone has the answer."
For contrarians such as Ram Bhagavatula, managing director of the hedge fund Combinatorics Capital, the interest rate equation is about to change. He believes the cyclical economic recovery will become the driver of the fixed income market — not the fiscal cliff, when automatic tax hikes and spending cuts are set to kick in on Jan. 1.
"The bear market in fixed income is here," he said. "The last piece of the puzzle — housing — is turning around. Loan demand is picking up. The temporary [economic] slowdown is done. Interest rates are too low given all the economic indicators."
Strategies: What and Why
So what's a retail investor to do? We asked strategists, money managers and financial planners to share their outlook and investment choices.
Bulls or bears, all of them say the short end of the market is where to be. But some also like aspects of the long end.
For Bhagavatula, it's the front end of the market because investors can afford to hold their Treasurys until maturity while not losing any principal. "Recovery risks and inflation risks show up first in the long end," he said.
For Awad, the "sweetest" time frame is bonds of two to five years.
For Lon Erickson, portfolio manager of fixed income at Thornburg Investment Management, it's three to seven years.
For Scott Kimball, a portfolio manager with Taplin, Canida & Habacht, it's three-year high yield debt, along with investment-grade corporate bonds.
Differences in strategy, however, emerge in allocation, with some portfolios more diverse than others.
Kimball's barbell approach is based on the assumptions that "the GDP concern, the growth concern, is going to drive the bond market in 2013" and that "political gridlock is going to be one of the banes of the market."
His firm's fixed income portfolio involves being overweight in long Treasurys and high-quality industrial commercial paper, along with some long-maturity Treasury Inflation Protected Securities (TIPS), for the sake of inflation risk.
"You could see longer-term rates come down," Kimball said.
Kimball said the firm uses corporate bonds for shorter-duration assets.