For more information about the funds discussed below and to find out how to apply, please see the Bond Funds section »

Bond investors have had a relatively good time recently with yields on corporate and government debt (bonds) offering a less volatile way to generate returns while interest rates are at a record low.

However, fund managers and commentators are increasingly warning of the risks associated with these interest paying assets. Although individually bonds pay a rate of fixed interest, known as the coupon, bonds are affected by market movements bringing down their face value if they become less attractive investments.

At the end of 2010, John Chatfield Roberts, chief investment officer at Jupiter Asset Management and part of the Merlin team which manages fund portfolios investing in bond funds, warned about the risks of bond investments in 2011.

Chatfield Roberts said at the time that government bonds were vulnerable to falls in their value demonstrated by rising yields, while investment grade corporate bonds were looking less attractive.

“While companies are generally in pretty good shape, their bonds are vulnerable to increases in government bond yields. Opportunities remain further down the credit rating spectrum but investors need to be very selective and focus on protecting against downside risk,” he said.

Active bond investing

Manager of the Old Mutual Asset Management Corporate Bond Fund, Stephen Snowden, has the facility in his fund to reduce the duration he holds bonds to zero. This process is similar to taking a short position on shares, in that it allows the fund to enter a contract to sell a bond at a predetermined price at a later date.

So if the fund believes the face value of a bond will fall it can guard against the impact of this by setting a higher price than the bond is worth at some point in the future.

Old Mutual said the efforts to stimulate developed economies through economic policies such as quantitative easing had driven down government bond yields, which means bond prices have increased.

“However, sooner or later the policy will be reversed. Interest rates are at historical lows – in the UK they haven’t been at these levels for over 300 years – but must begin to rise at some point as economies recover. When this happens, bond prices may fall,” the company has said.

Snowden said he sees ‘great value in credit; valuations have cheapened again and balance sheet repair is continuing, so risk of corporate default is falling.’

Concerns about some EU nations ability to repay their debt, means the fund is taking a cautious approach, with an increase in the fund’s exposure to high credit rated AAA bonds at the end of 2010, as well as taking advantage of attractive valuations in corporate bonds in the EU periphery countries, e.g. Telefonica in Spain and Portuguese electric utility EDP.

Credit risk

High yielding corporate debt refers to companies with lower credit ratings and therefore higher risk of that company defaulting and being unable to repay its debts. Several commentators have talked up the potential for returns in this area as corporate cash flow improves during the recovery, but specific risks of default with specific firms remain.

Funds in the strategic bond Investment Management Association sector have greater flexibility to invest in higher yield corporate bonds, which can provide attractive returns, if at higher risk, in a diversified bond fund.

Strategic bond funds have remained a popular investment theme, with IMA statistics showing it was the most popular sector for investors in 2010.

Options for strategic bond investing

Examples of strategic bond funds are the M&G Optimal Income Fund which can invest in a wide range of fixed income assets issued by companies with different credit ratings to maximise the level of income generated.

The L&G Dynamic Bond Fund has a similar flexible approach with investments in corporate and government debt, as well as taking short positions on bonds if falls in value are anticipated.

The Henderson Global Investors Strategic Bond Fund has a similarly diversified portfolio with over 40 per cent of its holdings in higher yielding bonds from issuers with lower BBB and BB credit ratings.

Inflation

While uncertainty over interest rates is having an impact on bond investors the impact of inflation on the real return from investments is of increasing concern. While the Consumer Prices Index (CPI) official measure of inflation is currently at 3.7 per cent, studies put the impact on people of increases in everyday costs higher.

Stewart Cowley, manager of the Old Mutual Global Strategic Bond Fund said modelling based on daily spending suggested the inflation rate on people is closer to five per cent, making returns particularly on straight investment in government bonds poor in real terms.

A strategic bond fund, such as the Old Mutual fund is able to hold a diverse range of different bonds to maximise the return generated, as well as using the negative duration strategy discussed above.

Another option for combating inflation are investments that are linked to the level of inflation, or index linked investments.

See Vanguard Launches Inflation-Linked Tracker Fund for more information on a new passive fund from Vanguard investing in government bonds.

The Old Mutual Corporate Bond Fund, M&G Optimal Income Fund, L&G Dynamic Bond Fund, and Henderson Global Investors Strategic Bond Fund are in the Fair Investment Select 100 »

For more information on the range of funds available through Fair Investment visit the Investment Funds section »

No news, feature article or comment should be seen as a personal recommendation to invest.

The value of investments and income from them can fall as well as rise and you may not get back the full amount invested.

Different types of investment carry different levels of risk and may not be suitable for all investors. Prior to making any decision to invest, you should ensure that you are familiar with the risks associated with a particular investment. If you are in any doubt as to the suitability of a particular investment, both in respect of its objectives and its risk profile, you should seek independent financial advice.

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