In 2013, fixed-income investors are facing a new frontier. “We’ve never seen the bond market look less attractive than it does now,” declares Mitchel Schlesinger, chief investment officer at FBB Capital Partners in Bethesda, Md.

It’s not any single event that’s inspired the pessimism. Indeed, the causes for bond jitters are myriad. Inflation, which has been kept in check for the past several years, seems overdue to rise—which wouldn’t be so bad if bond yields were higher. Add the still-unsteady global economy and you have a recipe for anxiety and volatility, if not outright disaster. “The decades-long bull market for bonds is over,” laments Harry Clark, chairman and CEO of Clark Capital Management Group, an independent RIA in Philadelphia.

Of course, it is precisely this kind of financial fear that’s engendered the past several years’ massive inflows to bonds as a safe harbor, causing, in turn, what some now call a bubble. “When investors get scared, they buy U.S. government securities,” says Joseph Balestrino, senior vice president and chief market strategist at Federated Investors in Pittsburgh.

Balestrino, who manages a fixed-income portfolio, primarily means T-bills and Treasurys. The benchmark 10-year notes—safe, conservative, federally backed—have maintained yields under 2% for longer than most observers thought possible. “For the near term, which we think will remain highly volatile, you might as well hide out in Treasurys, which have no default risk,” he explains. “But once we get past these headlines—perhaps in the second half of 2013—then you buy higher yielding asset classes.”

There are risks to betting on Treasurys even in the short run, however. They are “a bubble that’s bound to pop,” says Chris Gaffney, senior vice president at EverBank in St. Louis. “Institutional investors continue to ‘hide’ in these bonds as a liquidity haven, but these aren’t long-term strategies. These same investors will quickly head for the exits as soon as better opportunities present themselves.”

Moreover, even if interest rates stay low, that’s no guarantee Treasurys will stay cheap. “Although the federal-funds rate will be likely on hold for a while, bond yields can fluctuate,” says Alan Cohn, co-president of the Sage Financial Group in Conshohocken, Pa. “That means so can bond prices.”

The Hunt For Yield
The search for worthwhile yield has been the No. 1 concern of bond investors for several years. It leads many to increase their risk tolerance. That can mean looking overseas, particularly to emerging markets. But besides default risk,
emerging-market debt has added layers of political and currency risk. Many yield-hungry fixed-income investors feel more comfortable with high-yield corporate bonds. Typically, these are issued by smaller companies, which are “not as inflation-sensitive as big companies because they have pricing power that big companies don’t,” says Clark, the RIA in Philadelphia, “and defaults in high-yield corporates are pretty low.”

The sort of high-yield corporate bonds that Balestrino forecasts will be “good choices for the second half of 2013” are primarily in business-services sectors rather than anything tied to retail sales, he says, because of “the likelihood of continued weak employment.”

On the other hand, he sees promise in the gradual recovery of manufacturing, “especially in housing and auto production,” he says.

Investment-Grade Corporates
Not all fixed-income market participants agree that these riskier securities are preferable. “High-yield and emerging markets are overvalued,” asserts Scott Kimball, the Miami-based senior portfolio manager of the Core Plus bond fund at BMO Global Asset Management subsidiary Taplin, Canida & Habacht. He favors investment-grade corporates, primarily in the real estate investment trust and telecom/media sectors.

Richard Platte, portfolio manager of the Ave Maria Bond Fund, based in Bloomfield Hills, Mich., agrees that investment-grade corporates are desirable given current conditions. “With interest rates at historical lows, our focus has been on protecting principal, rather than maximizing yield,” he explains.

Short-Term Maturity
Shortening maturity is another sound strategy for surviving fiscal uncertainty. Short-duration bonds allow for a greater degree of flexibility. “Bonds bought today will not be sold at a profit if interest rates rise,” points out John Gerard Lewis, principal at Gerard Wealth Management in Olathe, Kan. “Therefore, they should be bought with the intention of holding them to maturity, and thus the higher priority is bond quality.”

While buying corporate bonds individually “gives you a known yield and maturity date,” he adds, his preference is for short-term investment-grade bond funds, which can continually reinvest as rates go higher. He especially prefers “high-quality, closed-end bond funds, which use leverage to yield 4% to 5%,” he says.

Whether investment-grade or high-yield or whether of long, intermediate or short maturity, corporate bonds have undeniable advantages over their government-backed counterparts. “Rates, even on reasonable ‘BBB’ corporate bonds, are yielding a taxable 3.3%,” says Paul Bolster, Harding Professor of Finance at Northeastern University in Boston.
“That’s not much after-tax return, [but] an investor can at least pick and choose among credit qualities and growth prospects among corporates.”

Mortgage-Backed Securities
Others suggest leveraging the upturn in building by investing in mortgage-backed securities (MBS). Broadly speaking, there are two types—residential and commercial. Brad Friedlander, co-founder and head portfolio manager of Angel Oak in Atlanta, likes non-agency residential mortgage-backed securities (RMBS), which are secured by home mortgages. “They are less sensitive to interest rates and provide higher income,” he says.

Donald Quigley, New York-based portfolio manager of the Artio Total Return Bond Fund, recommends commercial mortgage-backed securities (CMBS). “The yield differential between the CMBS bonds and similarly maturing corporate bonds is still wide enough compared to their long-term historical average to justify holding a position in them,” says Quigley.

Commercial mortgage-backed securities tend to have less of a prepayment risk than residential, since the former are often set for a fixed term, and residential mortgages might not be. On the other hand, commercial mortgages can be hard to value because they aren’t standardized to the degree that residential ones are.

Other Government-Backed Fixed-Income Securities
Kimball, the portfolio manager at Taplin, Canida & Habacht, also recommends Treasury Inflation-Protected Securities (TIPS). Issued by the U.S. Treasury, TIPS are inflation-indexed. Their principal increases if there’s inflation and decreases with deflation; at maturity, the bondholder receives whichever amount is higher—the original or adjusted principal. Moreover, TIPS pay a twice-yearly fixed rate of interest—a preset percentage of principal so that, as the principal changes, the value of the interest payments does, too.

TIPS are low risk, since they’re backed by the federal government, though unlikely to realize significant returns. They are also exempt from state and local income taxes, though their twice-yearly inflation adjustments are federally taxable as income, even if you haven’t sold them or they haven’t reached maturity yet.

For the risk-averse, there are other types of government bonds, of course. In recent years, many have flocked to municipal bonds, or munis. One attractive feature of munis is they are tax-free. But this becomes less of a pull if your taxes aren’t all that high to begin with. “Municipals will benefit from higher federal income taxes coming down the pike,” says Wayne Schmidt, chief investment officer at Gradient Investments in Shoreview, Minn. “This sector has already performed so well in anticipation of higher income tax rates, but higher tax reality will give this sector another small boost.”

Still, munis are not high on Schmidt’s list. “Municipal bonds are already priced close to perfection,” he says.

So Schmidt prefers corporate debt in the form of an exchange-traded fund. “The most interesting values in the bond market today are new bullet-share ETFs,” he says, “whereby individual investors can now own either an investment-grade or high-yield portfolio of diversified corporate bonds with a specific maturity year.”

To be sure, the fixed-income part of a portfolio doesn’t have to be made up of one type of bond or another. In fact, many portfolio managers recommend a diverse basket of instruments. “We believe in a balanced approach to fixed-income investing,” says a joint e-mail from Douglas Folk and Chris Fitze, co-managers of the Touchstone Total Return Bond Fund at Earnest Partners Fixed Income in Atlanta. “A blend of corporate bonds; agency single-family and multi-family mortgages; and government-backed agency securities, like the issues out of the Small Business Administration and the Export-Import Bank, look promising.”

Keeping Agile and Vigilant
A mixed bag may prove to be the best medicine for fixed-income participants in an ever-changing market, but it’s also clear they should maintain vigilance. “What is in favor now or in the very near future could quickly reverse, becoming out of favor almost overnight,” cautions Brad Thompson, chief investment officer at Stadion Money Management in Watkinsville, Ga. “Hence, we believe a tactical approach to fixed income is more important now than ever.”

That tactical approach will no doubt require perseverance and an open mind. “Bond investors will probably need to get increasingly clever to find pockets of attractive yield,” says Bob Elsasser, director of fixed income research at CTC Consulting in Portland, Ore. “Bonds have delivered a lot of magic in investor portfolios over the last several years, but I doubt there is another rabbit in the hat for 2013.”

Then again, bondholders might not be looking for magic anymore—just a degree of comfort and predictability. “Fixed income has become the haven for a great number of investors trying to escape a decade of bubbles and asset volatility,” says Scott Colyer, chief executive officer and chief investment officer at Advisors Asset Management in Monument, Colo.
“Demographics also support the fact that the population of risk-averse investors is growing as the boomers confront their retirement years. … [Today], the debt markets are shared by the greatest percentage of the population who are seeking a sense of ‘sleep at night’ comfort more than return on investment.”