Investors were last week given a powerful signal to buy corporate bonds when the Bank of England said it intended to buy billions of pounds worth of British company debt.

Fund managers said the Bank’s announcement of a £50 billion fund to buy company assets — including high-grade corporate bonds — would prop up a sector that has been hampered by fears of defaults as the recession deepens.

Corporate bonds are in effect IOUs issued by firms when they need to raise finance. Investors lend the money for a fixed term and earn a fixed rate of interest for the duration. At the end of the term, investors get their money back in full — unless the company goes bust.

Bond prices fell sharply in the second half of last year as the market worried about the impact of the economic downturn on companies’ ability to repay their debt. This has pushed yields to levels not seen since during the Great Depression (yields rise when prices fall).

Jamie Stuttard of Schroders, a fund manager, said: “We expect 2009 and 2010 to be periods of strong total return for corporate bonds — albeit with continued volatility to navigate.”

For example, a bond from Tesco issued in 2006 at 5.2% is yielding 6.9%, despite being widely regarded as highly unlikely to default.

Corporate-bond funds, yielding up to 10%, saw record inflows in the last three months of the year amid the search for income, and advisers expect the trend to continue.

However, experts question whether all investors understand what they are buying, so here we offer a guide.

How do bonds work?

Suppose a bond is issued at £100 with a yield of 5%, or £5 a year. If interest rates are expected to come down to 4%, that 5% looks attractive and investors pile in. This pushes up the price to, say, £110. The bond is still paying £5, though — equal to a yield of 4.2%, which is more in line with the market.

Why is the government buying bonds?

The sector was hit hard when the US investment bank Lehman Brothers collapsed in September, wiping out bondholders as well as shareholders. Prior to that, it had been thought governments would not let bondholders lose money.

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