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The corporate bond sector is likely to be one of the biggest winners emerging from this year’s Isa season. Anaemic rates on cash savings have forced investors to look elsewhere for income and – with large cuts in dividends on the cards – equity income is still too risky for many.

A recent survey by uSwitch, an independent consumer comparison service, suggested approximately 4.3m investors planned to take money out of cash Isas. It estimated this was equivalent to roughly £9.5bn. Much of this money is likely to end up in the corporate bond sector, where investors can still find generous yields and greater potential for capital growth. Corporate bonds already saw strong inflows in December and January from both retail and institutional investors.

But the economic situation will undoubtedly take its toll. Defaults are rising and, while a high default rate is already priced in to the corporate bond market, significant risks remain.

The first main area that will influence fund manager performance over the next 12 months is the position on banks, which can make up as much as 40 per cent of the corporate bond indices. Bryn Jones, manager of the Rathbone Ethical Bond fund, says: “If the banks get things sorted out, there could be huge upside in these bonds and investors could double their money. But if there are still problems in 12-18 months’ time, particularly if subordinated debt coupons are withheld, investors could lose their income as well as their capital. As such, there are huge risks in buying banking debt.”

He believes it is dangerous to be out of banking names completely, but it is not an area where he is overweight and he is picking his names carefully. Curtis Evans, fixed income product manager at Fidelity International, also believes navigating financials will be vital to performance this year, but adds that much of the performance of the banking sector will come down to actions by the government and the Bank of England, which remain difficult to predict.

But the decision for fund managers is not just which banking bonds to hold, but also which type of debt. Mr Jones says the government has not yet made it clear how subordinated debt will be treated upon nationalisation. There is a possibility the lower tiers in the debt structure will not pay a coupon, which has seen these types of bonds marked down significantly. He says anyone reinvesting in banking-sector debt needs to take this into account.

With a potentially huge number of businesses defaulting on their debt, credit analysis will also be vital across the board this year, not just in the banking sector. John Hamilton, head of fixed interest at Jupiter Asset Management, says bond investors need to be circumspect because every downgrade by the rating agencies will lead to a higher cost of capital.

“The problem facing a lot of companies is refinancing risk. There is still poor liquidity in secondary markets and those markets are discriminating between companies that need to refinance and those that don’t. Market liquidity is improving, but until some companies make progress on refinancing, their bonds will continue to trade at distressed levels,” he says.

Mr Hamilton believes companies need to be well managed and flexible in their financial structure and in their access to cash. There is some movement down the risk scale, but most managers are now sticking with higher-quality bonds.

He says: “The safe-haven qualities of government bonds will fade, and people are seeing real value at the A or BBB level of non-financial, investment-grade bonds.

“We’re looking at that ourselves. But the lower-quality, high-yield issuers have some big risks coming up and default rates are likely to go quite high.”

Mr Evans says Fidelity remains defensively positioned. Its fixed income team is sticking with consumer staples such as tobacco or soft-drinks producers, while avoiding areas such as insurance and discretionary retailers where it sees little value. The team is also picking up selective new issues.

He adds: “High yield is more susceptible to economic reality and is more likely to see defaults. You need to pick your names right.”

Mr Jones is snapping up many of the new bonds coming to the market, which are being issued at high spreads over government bonds. He says: “To attract demand in January and February, these bonds have come to market at much higher premiums. Vodafone came at 400 basis points over gilts, while its bonds in the secondary market were only trading at 250bps over gilts. Imperial Tobacco came to the market with a coupon of 9 per cent. These are cash flow-generative businesses that will continue to perform.” For the time being, this phenomenon is only being seen in the sterling market.

Gary Potter, joint head of multi-­manager at Thames River Capital, says liquidity is the other important area for corporate bond fund managers. He adds: “No one knows how high default levels will go. Issuance is increasing and there is a huge supply of corporate bonds. As a result, quality is our main criterion. We look at groups such as Invesco and M&G, which are taking in good amounts of money and will therefore not have to be forced sellers in these illiquid markets.”

Mr Hamilton also believes liquidity will be vital. “If you can make a call on how liquidity will sort itself out, it will be important for performance. If liquidity improves, there is likely to be an improvement in spreads, so fund managers need to get it right in terms of duration.”

Mr Potter says prudent pricing of bonds is crucial. He adds some fixed income managers have been valuing the bonds on their books based on the average available from market makers. When it comes to sell those bonds, the actual price realised is lower. He says: “Those that took a more aggressive approach to pricing have seen their portfolios marked down significantly.”

Aidan Kearney, head of UK multi-manager at Credit Suisse, says in the instances where he takes credit exposure in his funds, he looks for very conservative, fundamentals-driven managers. He uses specialist fixed income investment house Bluebay.

That said, he is keeping a spread across the fixed income spectrum, holding Invesco Sterling Bond as a beta play on the credit space and Franklin Templeton Investments and Julius Baer for government bonds and currency.

Mr Potter believes this year may see a significant difference between the returns of different corporate bond fund managers. Decisions on the banking sector, liquidity and their skill at analysing credit risk will all affect performance, along with the experience of these managers.

Could the government’s plan to buy back bonds help some companies and inject increased liquidity? Mr Jones thinks not, because the government is apparently focusing its attention on areas of the market where there is already good liquidity.

He says: “This is supposed to take a reverse auction process, whereby we can sell our bonds back to the Bank of England. Unfortunately this is only the businesses we can sell anyway. It might help some of the property companies, but for companies like Nationwide, the government is apparently not interested.

“It will crowd the market out even more, making it cheaper for larger companies to refinance, which monetary policy has done anyway. It won’t help where it’s needed.”

Cherry Reynard is a freelance journalist