The answer would seem to be to move into the higher yield end of the market, where valuations are more compelling. Yet if economic indicators worsen, or major developed market economies fall into a double dip, there is likely to be widespread risk aversion and few buyers for higher yielding corporates. It is a significant dilemma.
There are still those that will argue that there is value in gilts. After all, if base rates stay at 0.5 per cent for any length of time, gilt yields of 3 per cent still look attractive. And there is plenty to suggest that interest rates may remain low and government bond yields are in a long-term decline.
Fixed income sectors, 3-yrs
Source: Financial Express Analytics
Mike Riddell, a fixed income portfolio manager at M&G, said of the US government bond market and the 'new normal' of low interest rates: "The ten year Treasury yield today is almost exactly in line with the average Fed Funds rate of the last decade. So it doesn't appear that the bond market is pricing in a 'new normal' at all, it is simply pricing in a repeat of the experience of the past decade."
"Given that the 10 year Treasury yield is at 2.8 per cent today, which is where the Fed Funds rate has been for the last decade, you should be very bullish on the direction of US government bond prices if you believe that the US is about to enter a 'new normal'. The same could apply to the UK or other developed markets."
Nevertheless, the smart money appears to be heading to the higher risk end of the bond market. For example, Andrew Yeadon, head of multi-manager, at Schroders has a significant overweight in the IMA Sterling High Yield sector, premised on the fact that default rates are relatively low and valuations look compelling.
"Gilts look over-valued and ought to move higher," he said.
"They will not move to yields of 5 per cent any time soon, but when the 10 year Gilt hit 2.9 per cent, it was a step too far. They are likely to drift higher as chances of a double dip diminish," Yeadon added.
Fitch Ratings recently reported positive flows into credit funds over the second quarter, but added that the majority of these investments were moving into high yield and emerging market debt where yield levels are higher. Another argument in favour of the corporate side of the bond market is that corporates look to be in good shape.
Yeadon said: "The corporate sector continues to have good news coming through. Corporate earnings should grow into 2011."
Fund selectors in general are leaving the decision to the bond managers themselves.
Monica Tepes, fund analyst at Killik & Co, said: "We are looking for managers that have the flexibility to deal with these different issues. This would be funds such as the L&G Dynamic Bond fund, which is run on a total return basis. It will hedge out credit and interest rate risk when necessary and sells protection on some names, so manager Richard Hodges is well-positioned if things move against him. He can invest across the market spectrum."
Tepes also likes the M&G Strategic Corporate Bond and Invesco Perpetual Income funds, which would be beneficiaries of any flight to safety.
The outlook for fixed income remains difficult to predict. Bonds could be in a bubble, yet they could be seeing long-term yield compression. Spreads over government bonds are historically wide, but corporates may suffer if there is another lurch down in economic conditions. For the time being, the momentum seems to lie with the higher yielding end of the market, but intermediaries are taking a cautious approach and leaving the decision to the experts.