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Since September and the default of Lehman Brothers, credit markets have developed severe schizophrenia. Bonds benefit from a deflationary environment, as their fixed coupon becomes relatively more valuable. This has been reflected in the market for UK gilts, which have been just about the only asset class to rise steadily over the past three months.

But a recession also increases the likelihood of companies going bust. Fears of defaults push yields on corporate credit higher than those on government bonds, as sellers have to offer more jam to lure in buyers.

Richard Woolnough, the veteran bond fund manager who now works for M&G Investments, believes bond markets are underestimating the macroeconomic risks facing the UK, but – more importantly – exaggerating the risks of default.

“The credit markets are expecting a repeat of the 1930s. They're discounting really bad news. Even if we do get really bad news, you have to own credit. Only if we get really seriously bad news is it worth waiting,” he says.

Mr Woolnough runs two M&G products in the IMA Sterling Corporate Bond sector: the £1.1bn M&G Corporate Bond fund and the £192m M&G Strategic Corporate Bond fund. The former – one of the oldest funds in the sector – is more diversified and conservative. The latter gives the manager scope to “express views in a far more concentrated manner”.

His views are currently highly bullish. With spreads at record highs, he introduced credit risk back into the Strategic Corporate Bond fund for the first time in more than three years this October. He continues to buy what he considers oversold credit instruments in anticipation that investors will eventually regain their heads and valuations will normalise.

But while Mr Woolnough’s corporate outlook is more positive than that of the markets, his macroeconomic outlook it more negative. He believes that although last month’s historic 150 basis point rate cut made investors aware of the deflationary risks in the short term, markets are still not pricing in sufficiently low interest rates in the medium term.

“As a bond investor, we’re looking at the average interest rate and inflation rate over the next five years, not what the headline rate is today. The markets are pricing for rates to normalise over time, whereas we think they will stay low for longer than expected,” he explains.

But stock picking in the credit universe, rather than taking a strong macroeconomic view, is the major driver of returns at the moment. Mr Woolnough stresses the importance of both strategies, but says one tends to gain ascendance over the other at different points in the cycle.

“In benign conditions for credit it’s hard to add a great deal of value through credit risk, so it’s your duration decisions that will drive performance,” he says, citing the period from 2003-07 as a prime example.

“The question I was asking our credit analysts two years ago, when spreads were very tight, was: ‘Which ones go wrong?’ If you’re not being paid for taking credit risk, you spend your time avoiding it,” he notes.

The opposite has been true since the summer of 2007. Interest rate bets have been “dwarfed” by having the right credit and sector bets, according to Mr Woolnough. His discussions with the credit team are now more positively framed.

“The question I’m asking now is: ‘What are the good things to buy?’ If you are being paid to take risk, you ask which of the assets is overcompensating you for that risk,” he says.

The shift in market conditions had a positive effect on the fund’s track record. Having accrued a narrow gain over the sector average from launch in 2004 until mid-2007, it leapt ahead of the pack when the credit bubble burst. M&G Strategic Corporate Bond is now ranked second in its peer group over three years to November 17.

Avoiding banks has been one of the main drivers of returns. The manager reduced exposure to financials from roughly 35 per cent in 2007 to 5 per cent by the beginning of this year. “We had a view that the banking sector would have problems coping with the collapsing UK housing market. We avoided the weaker banks,” he recalls, adding that avoiding companies such as Lehmans and AIG also helped keep the one-year track record more or less flat.

Now, Mr Woolnough is buying some financials back. “The market is slowly working out who the losers and who the winners are,” he says. He is also hunting out stocks that have been hurt in the general sell-off but that show anti-cyclical qualities. The most obvious example is utilities.

“The utilities have business plans that are viable for a slowdown, even a severe one,” he observes.

The manager is also spotting opportunities within the high-yield universe. He purchased some largely BB rated bonds in March, during the sell-off that followed the collapse of Bear Stearns, and again in October, in another wave of investor panic. Sub-investment-grade debt now amounts to 4-5 per cent of the total portfolio.

Mr Woolnough stresses his reliance on M&G’s battalion of analysts when buying high-yield credit. “Two men can’t run high yield. You need a extensive dedicated team. The main drivers of returns are probability of default and recovery on default, so it’s important to have legal teams as well as credit analyst teams to look at the effects of restructuring,” he says, adding that this was something he lacked in his previous position at Old Mutual.

The manager urges investors to consider the Sterling Corporate Bond sector in its current distressed state. “It’s a good opportunity to look at credit, even if you decide not to include it in your portfolio. This is the cheapest corporate bonds have been since the sector was launched in 1994.”