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Rarely has the saying 'caught between the devil and the deep blue sea' been so apt than at this juncture in the global financial crisis.

In the boom years, the words 'inflation' and 'deflation' - neither particularly desirable - were whispered with caution. Now they are being bandied about with gusto, as the world faces up to the scale of the current financial mess.

Affiliation to a particular camp - inflationary or deflationary - is proving divisive and having a profound impact on investment decisions. In the bond universe, this dual threat is creating a tug of war between the crowded safety of government paper and the slightly riskier, but altogether more rewarding, corporate bonds.

Confidence is at an all-time low, causing people the world over to deleverage and increase their savings rate. For as long as money is hoarded in this way and the velocity of money continues to be close to zero, the threat of deflation will loom.

Central governments, namely the Bank of England and the Federal Reserve, have tried to shake up this uneasy situation by initiating huge stimulus packages in the unconventional form of quantitative easing (QE) to increase the circulation of money and stimulate economic activity.

QE is not as simplistic as just printing money, but instead involves the purchase by central banks of government and private-sector debt or bonds. The aim of the exercise is to drive down longer-term interest rates - the kind that effect mortgages in the US and enable companies to finance themselves more cheaply in the UK, helping to stop the spread of insolvencies that are exacerbating the crisis.

Many commentators, however, are sceptical of such short-term intervention and have gone so far as to claim QE is a social experiment or, as one dissenter put it, "a Band-Aid solution for a gaping, almost mortal wound".

It has been argued such reflationary policies from central banks and governments globally will create an inflationary environment. But the reflating of asset prices will not guarantee the immediate resumption of trade to the levels seen in the recent past. The starting line has been dragged back too far for that - as highlighted by the complete collapse of world trade in the fourth quarter of last year.

The need for western consumer societies to deleverage at both the personal and government level is ever more prevalent. Until the point where the central banks’ reflation is greater than the global credit deleveraging, the threat of deflation will remain.

Such a balance is difficult to strike. The line between the purchasing of government and private-sector bonds on the open market on the one hand, and the need for governments to issue large quantities of debt to pay for the extraordinary levels of bailouts and fiscal stimuli on the other, is smudged. An oversupply could wreak havoc in the market by creating a false rally that could soon give way to rising yields, with the lethal potential to debase a currency.

Having acquired a huge volume of US Treasuries, China’s leaders are feeling increasingly anxious watching the US government stretch the budget deficit yet further through the continued use of QE. They see that it will erode the US government's ability to repay its debt. It is a stark indicator it is no longer permissible to assume major sovereign credits are free from default risk.

The markets are obviously on high alert to any falling demand for government bonds. Recent issues that went poorly in both Germany and the UK have attracted some attention, but as yet there has been no concrete evidence of any unwillingness on the part of the markets to participate.

The predicament is an intriguing one, as governments' deflation fix is the very thing giving rise to the spectre of inflation. Such a scenario is unprecedented, which explains why the debate surrounding how to invest is so fervent.

A deflationary environment is a bond's best friend, as in times of stress investors flock to the safety of investments with a guarantee, such as government or corporate bonds with their fixed maturity and coupon. But this crisis has been so pronounced corporate bonds have been sidelined, as investors have deemed the potential for corporations to default on their loans too high.

There has been extraordinarily high demand for government bonds as a result. As is always the case with high demand, the yields on these bonds were pushed to dramatic lows. Investors buying at this point were effectively handing over money to the government to park their cash in a safe and liquid place. It is time to face facts: risk-free cash is earning zero interest, and this behaviour no longer makes sense.

Such an indiscriminate retreat from risk, coupled with a desire for decent returns, is leading investors to the middle ground of solid, straightforward corporate bonds. A little while ago, as the news flow grew ever more pessimistic, investors bolted from corporate bonds. But these panic-induced exits have resulted in the smart money being overlooked. Spreads on corporate bonds are still as attractive as we have seen since the 1930s, and with careful credit research, it is still possible to identify cash-rich, well-financed corporations with minimal default risk.

There is no such thing as a perfect corporate bond because an element of credit risk is always present. But without the risk, there is no return pick-up. When looking at companies with a large amount of debt on their balance sheet, it is vital to ensure there is a steady earnings stream before investing. It is also best to avoid cyclical industries, such as autos, in favour of the consistency of telecoms and utilities.

Refinancing is also a massive issue. Even mid to large-sized companies are having difficulty refinancing, despite good earning streams - a clear indicator the credit markets are still distressed. One contributing factor is the newly released government debt, which is crowding out private companies and individuals from the lending market.

Whether you are a government or a corporation, the challenge for borrowers today is simply to stay in business. The challenge for the investor, however, is to decide the right balance between the security of low-yielding government bonds – which could potentially have negative real returns – and the more attractively priced corporate bond space, where the risk of default is still high in some cases.

The timing of this decision will be determined by the outcome of the deflationary versus inflationary debate. If deflation persists, due to the sheer magnitude of the current credit destruction and deleveraging, government bonds will probably be the more prudent investment. But if governments globally are successful in reflating their economies and deflation is avoided, corporate bonds will be one of the most attractive investment options in a generation.

Steven O’Hanlon is head of fixed income at ACP Partners (soon to merge with TriAlpha Investment Advisors)