Why the straight As may not make the grade in future

Investors who have poured their cash into corporate bond funds, many of them sold by high street banks, could be in for a nasty surprise. The upward march in interest rates could see their funds "hammered" over the next 12 months according to investment experts.

Fears are also growing that financial salesmen are using the bond funds' sparkling past performance to carry on pushing them at new investors while ignoring the gloomy medium-term outlook.

Fund managers warn the worst hit could be those who put cash into so-called "blue chip" trusts - those most sensitive to interest changes. UK government stocks have already lost 8% from their June peak.

Concerned fund managers have told IFAs to soft-pedal bond fund sales and dampen down expectations. And a number of IFAs have been given individual "guidance" to prevent a bond mis-selling epidemic.

Invesco Perpetual's Mike Webb says: "We've had private discussions with over-enthusiastic sellers over the past month. We have told them to downplay hopes. We don't want clients persuaded into bonds and then they lose money in what they thought was a safe investment."

"Past performance has been mis-used by IFAs and we have to avoid a rerun of the way our European equity fund was sold 1999-2000. It was flagged as the best performer but soon turned into one of the very worst. We have learned lessons," he adds.

At Isis, which has £15bn overall in bonds, manager James Foster asks: "Are investors fully aware of risks to their capital? Government and other quality bonds have already fallen. The rocket style past performance was due to special features not likely to be repeated.

"Bond fund investors should not rely on earning more than the coupon (the interest payments generated) and they could lose some capital. IFAs should be aware of the risks and inform their clients."

His solution to minimise the pain of further bond price falls as interest rates rise is to move into higher risk bonds, usually dubbed "junk".

"Junk fell dramatically last year on fears of huge defaults. That did not happen, so prices bounced back. They could still have some way to go plus giving higher income. And they get a boost from economic good times while top bonds prosper most in a recession."

The biggest sales have been at banks, which have pushed blue chip "investment grade" and "triple-A" style funds which may now be most at risk. Figures from Lipper for the first nine months of 2003 show Halifax has been the biggest seller with nearly £1.2bn; Lloyds TSB a net £436m from its Scottish Widows offshoot; and Barclays shifted more than £500m of bond funds from tied firm Legal & General.

Fund manager Theo Zemek at New Star is preparing for harder bond times. "My fear is that there will be a sharp upturn in long-term interest rates, which will result in capital values on some bond funds taking a hammering," she says.

"The trends that have kept gilt yields low and prices high include the move by pension funds into bonds, and the lack of new issues by the government. Both those trends no longer enjoy much momentum," she says.

Foster reckons the government will issue some £50bn of new gilts in 2004.

Zemek calculates that each 1% rise in the yield on a fixed interest fund implies a capital loss of 18%. "People in AAA funds will learn the lesson that bonds cannot defy gravity when rates are going up. There is a clear case for selling out of highly interest-rate sensitive bond funds and moving into the grottier end where you are less exposed to rises in base rates," she adds.

Webb at Invesco says: "Bonds have done very well, but it would be a mistake to chase them at this level. You will be lucky to get any more than the interest. Investors should not buy bonds as the major plank of their holidngs although they remain fine as part of a balanced portfolio."

What the bonds do and the likely returns

Bond funds invest in loan stocks such as "gilts" (from the UK government) and "corporate bonds" (from companies).

These fixed interest securities promise investors they will pay interest twice - sometimes four times - a year. This is known as the coupon.

Additionally, with a handful of exceptions, bonds repay holders a set sum on a stated future date. But there are no absolute guarantees. Bonds can and do miss out payments or default on their final promise.

And even the best quality bonds such as UK gilts or US government bonds cannot guarantee values until their repayment.

Bonds are primarily bought as income providers. But their values can go up and down in line with other interest rates.

And unlike deposit accounts, where your cash remains unchanged, the capital in a bond or bond fund can vary.

When interest rates fall, capital values rise. And when rates are increasing, as they now are, then capital values will drop.

Interest rate changes are not the only factor, however. Bond fund managers also look at the quality of the bond issuer. They want to know the the chances of a default either on interest or the capital.

And this is where credit rating comes in. Bonds are given a label ranging from AAA - the very best such as gilts - down to D, inches away from the corporate knacker's yard.

Lower credit ratings bring higher interest rates as investors demand a greater yield reward as compensation for increased default risk.

Top grade bonds are the most sensitive to interest changes. Junk can be more dependent on other factors such as the profitability of the issuing company and hence its ability to continue to service the debt.

Bond funds can concentrate on better credit ratings - investment grade - or on the lower level higher risk junk or on a mix of the two. Part of the fund manager's skill is weighing up the risks and rewards in the "spread" - the extra yield on junk compared with top quality bonds.