Bond funds have been riding high this year. In August investors bought £742 million of these funds, making them the most popular asset class among retail investors for the tenth consecutive month. In the same month, bond funds took three of the top five places in the bestsellers list compiled by Cofunds, the funds platform.

So why have they become so popular, and is it too late to join the party? Brian Dennehy, of Dennehy Weller & Co, the independent financial adviser, says: “It is down to a combination of fear and dissatisfaction. Fear of further stock market falls after the carnage of 2008 and dissatisfaction with the very low rates of interest being paid on deposit accounts.”

Those piling into bond funds have certainly enjoyed some good short-term performance. In the past seven months corporate bond funds have returned about 25 per cent on average, with the top performers registering mouthwatering returns of 50 per cent.

Although Mr Dennehy says the dramatic rise in corporate bond prices is over, he believes the good times have not disappeared entirely. “We won’t see the spectacular returns in the past few months of 30 per cent or more, but we could still enjoy attractive returns of about 10 per cent per annum.”

To start with, he says, bonds still look quite cheap in historic terms. Yields also look attractive, even if not as juicy as they were earlier in 2009. “With bond funds yielding anything from 4.5 per cent to more than 8 per cent, they still look pretty attractive compared with cash.”

This advantage is set to remain in place for some time, says Quentin Fitzsimmons, a director in Threadneedle’s fixed income team. He says: “We expect interest rates to remain low for the time being because central banks will not want to risk damaging any economic recovery by raising them.”

He adds: “We think that bonds are still attractive, but people will from now on be buying them for income rather than capital gain. In other words, after a spectacular appreciation in their capital value, bonds are reverting to their normal role as an income-producing asset.”

Another bonus is bonds’ low level of volatility. They also provide diversification for investors with a portfolio heavily invested in stocks and shares. Curtis Evans, of Fidelity’s fixed-income team, says: “The least talked-about benefit is the lower volatility which, when combined with bonds’ potential returns, makes them look particularly attractive.”

If you like the idea of putting some money into bond funds, which part of the sector should you go for? Should you go for the low-risk, low-yield end of the market and plump for government bonds, also known as gilts? Or should you try the riskier, but higher-yielding corporate bonds? Mr Evans thinks that corporate bonds at present look a better bet than government bonds. He says the credit spread — the gap between the return you get for holding a potentially riskier corporate bond rather than a government bond — is still quite high, even though it has narrowed a lot since March. He says: “The credit spread on corporate bonds is still wider than the peaks seen in the previous cycle.”

Mr Fitzsimmons’s team at Threadneedle likes both investment grade and high-yield corporate bonds, while remaining neutral about gilts.

However, Chris Huelin, head of fixed income at Collins Stewart Wealth Management, reminds investors that there are some caveats about putting money into bonds. He says: “We do not believe that the bond market is correctly pricing in the risks of inflation. We are uneasy as to whether these assets continue to offer value.”

Mr Dennehy is more optimistic, but agrees that investors need to be careful about what they buy. He says: “There is a huge difference between bond funds holding a large chunk of financials and ones that are less exposed to the sector. Last autumn and winter, funds holding bank bonds took a hammering as the financial sector looked to be on its last legs, but these same funds have soared since the spring.

“Before spring, fund managers couldn’t sell their bank bonds; now they wouldn’t want to sell them.”

Not surprisingly, perhaps, one of Mr Dennehy’s recommendations is a bond fund that has a large stake in financials. He says: “For an aggressive choice, I would go for Henderson New Star Sterling Bond fund. The manager, Stephen Thariyan, took over the fund at the bottom of the market and inherited a portfolio with a large slew of financial bonds. At first he was horrified, but he quickly recognised that there was value in the bombed-out financials and he held them through into the recovery with great success.”

His cautious pick is M&G Corporate Bond fund, run by Richard Woolnough. “He is the only bond fund manager who managed not to lose money last year. He very accurately anticipated the problems in the bond market and now he is cautiously rebuilding his holdings in banks.”

Justine Fearns, of AWD Chase de Vere, the independent financial adviser, likes M&G Optimal Income Fund, which aims to provide a total return using a flexible investment mandate. In addition to ordinary bonds the fund can invest in a small percentage of equities and in complex products known as credit-default swaps. Her second pick is L&G Dynamic Bond fund, another total return fund with a wideranging mandate.

“Richard Hodges, the manager, is free to roam across different regions and sectors to seek out good value wherever he can find it,” Ms Fearns says.

Case study: ‘Yields still offer good value’

David Armstrong has been investing in corporate bond funds for the past three years. Mr Armstrong, 64, a self-employed management consultant from Ovingdean, near Brighton, switched his investments out of managed funds and into three corporate bond funds run by M&G.

He says: “I now have about £50,000 divided roughly equally between M&G’s Corporate Bond fund, its Strategic Corporate Bond fund and the High Yield Corporate Bond fund. Bonds are less volatile than equities, and the yields they offer are attractive. They have done well this year but still look good value for money.”

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