Discussions about the impending "fiscal cliff" often are laden with tax and budgetary minutiae. And it is easy to become engrossed by the details, especially as they pertain to potential changes in tax rates.

But a preoccupation with the minutiae and the day-to-day political rhetoric can distract from how the fiscal cliff may shape the broader investment landscape. And it may be a landscape that warrants an increase in carefully managed credit risk, the ability to invest across multiple asset classes depending on relative value opportunities, and preparation for a possible long-term increase in inflation.

Despite the shortcomings of concentrating on the cliff's details, reviewing them at least makes it clear that the eventual outcome will not be a binary event, whereby the economy either goes over the cliff or avoids it. At this point, the most likely outcome involves a negotiated resolution that will whittle down the $670 billion involved in the fiscal cliff to within a range of $85 billion to $186 billion—what might be more accurately described as a "fiscal drag." (See Table 1.)

Adjustments to the amounts involved in the fiscal cliff may occur for a number of reasons, such as a postponement or reallocation of the spending sequestration; a reversal of the unpopular cuts in Medicare doctor payments; partial reduction in unemployment benefits and a gradual reduction thereafter; a partial reduction in the payroll tax; a resolution to the unpopular alternative minimum tax (AMT); and an increase in tax rates for only the top income brackets.

While a fiscal impact of $85 billion to $186 billion may not drive the economy into recession, it could restrain economic growth to a rate of about 1-2%, and keep the unemployment rate elevated in 2013. And given the Federal Reserve’s repeated declarations that the economy might be too lethargic to generate a notable improvement in the labor market, the central bank can be expected to continue its accommodative policies over the next several years. From the Fed's perspective, any additional fiscal drag makes aggressive accommodation even more appropriate and necessary if there is to be any improvement in the unemployment rate.

The Fed has already given itself a timetable of at least mid-2015 for an exceptionally low fed funds rate and carte blanche for additional asset purchases. Therefore, monetary policy in 2013 is likely to continue on its current trajectory, possibly with some amplification. These adjustments may be needed to address the impact of the fiscal drag and because Operation Twist¹ concludes at the end of 2012; also, the failure to initiate additional asset purchases in its place might be interpreted as a tightening of monetary policy.

While the Fed's potential purchases of additional agency mortgage-backed securities (MBS) or Treasury securities may continue to support the housing market's recovery, these policies would detract from the investment rationale for holding these securities. Indeed, a low fed funds rate would essentially anchor short-term yields at close to zero, and further quantitative easing combined with slow economic growth could keep the long end of these markets—and possibly others if the Fed broadens its scope of asset purchases—at historically low yields. In addition to low levels of income, any uptick in inflation could outpace these yields, essentially eroding investors' purchasing power and increasing the likelihood of negative real returns.

The risk of negative real returns increases the rationale for investors to assume more credit risk, therefore enabling them to potentially benefit from positive levels of real income and capital appreciation from tighter credit spreads. In this environment, high-yield bonds would be an option, considering the market offered yields of about 7% (as of early December 2012) and that the default rate in 2013 is expected to be 2.0%—less than half of the long-term average.²

An indiscriminate allocation to high-yield bonds, however, might concern some investors given the strong performance of the asset class over the past several years and the potential slowing of economic growth. But an actively managed strategy that can assess the ability of individual companies to continue servicing their debt obligations, and maintain or improve their profitability, may provide further opportunities for positive levels of real return.

In addition, a strategy with the capability to invest in multiple asset classes can seek out the best relative value opportunities not only in high-yield corporate bonds but also in floating-rate loans, convertible bonds, and the lower-rated tiers of investment-grade debt. This approach, for example, could provide exposure to some favorable attributes of floating-rate loans, such as rising levels of income with a potential increase in interest rates; higher historical recovery rates, given their place at the top of the capital structure; and relative stability from interest rate volatility, considering their minimal durations.

Finally, with the Fed's overt focus on the unemployment situation, the central bank could have a heightened tolerance for faster inflation. In that scenario, fixed-income investors' first inclination might be to gravitate toward Treasury Inflation Protected Securities (TIPS). Yet, TIPS generally have long durations and may experience adverse volatility if there is an increase in long-term interest rates. Another option would be to employ a strategy involving short-term credit securities and inflation-linked assets.³ This could provide a more targeted approach to inflation protection, with a limited increase in volatility from rising interest rates.

The unfolding events around the fiscal cliff surely are capturing investors' attention, and any resolution will have important implications. Yet, changes in the day-to-day political wrangling may not yield much insight into the upcoming investment environment. Instead, investors may want to keep focused on the various investment opportunities that may unfold as the fiscal cliff develops into the fiscal drag.