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As I write this article I am reminded of a speech given in Cape Town on 7 June 1966 Robert F Kennedy, who said: “There is a Chinese curse which says ‘May he live in interesting times’. Like it or not, we live in interesting times.”

With the tumultuous events that are currently unfolding in the markets, Mr Kennedy’s comments could easily be applied to the present.

The aim for all clients is to have the maximum potential return, based on the lowest risk, but how this can be achieved? Well, the simple answer is to have a diversified asset allocation appropriate to the risk that the client is prepared to accept.

In order to achieve this, we have seen the introduction of investment tools from various providers and sources and indeed some advisers have introduced a psychometric factfind linked to appropriate asset allocations.

A common theme of all of the risk analysis tools I have seen is something called an “efficient frontier”. This is a curved line plotted on a chart of expected return against standard deviation.

Of course, with reference to an efficient frontier it must be remembered that the past performance data used is crucial. Portfolios along the frontier are all “efficient” – an investor has to select the portfolio that best matches his risk criteria.

In very simple models, “risky” equities are combined with less risky fixed interest bonds and with very low risk liquidity to provide a much less risky overall portfolio.

The question is why, when combined with other assets such as equities, does a holding in fixed interest securities reduce risk? Again, trying to keep it as simple as possible, fixed interest securities behave differently to equities and cash, depending on the prevailing economic conditions and expectations.

This is probably best explained with an example. If the expectation is that inflation will be higher in the future then in general, bond funds will suffer - apart, of course, from index-linked funds – while equities have historically been viewed as a defensive asset class in inflationary times.

If, however, the expectation is that inflation will be lower in the future, then the next question might be what the outlook is for short term interest rates: will they rise or fall? If for some reason short-term interest rates are expected to rise, then the best place to invest might be cash. If the expectation is that short term interest rates are likely to fall, then you might ask whether the economy is heading for recession. If it is not then equities might be tempting, but if it is then bonds will prove to be attractive.

It is therefore possible to say that, in general, fixed interest securities and equities as asset classes are negatively correlated. Fixed interest has typically produced positive returns when equity markets have fallen, so including fixed interest assets in a portfolio can help offset or reduce negative returns during periods of market volatility.

For individuals prepared to accept a higher risk and therefore a higher allocation to equity assets, an allocation to fixed interest can reduce the extremes of portfolio returns and reduce total risk or standard deviation. For more cautious investors it helps to preserve capital.

Of course, all of this is academic analysis based on the concept of an “asset class”, and within an asset class such as “fixed interest” there are many variations and choices to be made, some of which conform or otherwise to the general investment principles for the class.

In terms of the various fixed interest choices available in order to help advisers analyse the Fixed Interest sector, on the 1 September the Investment Management Association created some new fixed interest fund sectors. The UK Corporate Bond and UK Other Bond sectors have ceased to exist to be replaced by Sterling Corporate Bond, Sterling Strategic Bond and Sterling High Yield Bond sectors. The aim is to define the differences between funds in different sectors more clearly.

The Sterling Corporate Bond sector includes funds that invest predominantly in higher-rated bonds, the Sterling High Yield Bond sector includes funds that invest at least 50 per cent in higher-risk, higher-yielding bonds, and the Sterling Strategic Bond sector includes funds that invest across the spectrum in a mixture of higher and lower-rated bonds. The new definitions are more specific and tighter and provide more clarity between the different types of funds in the fixed income sectors.

Full details of the new definitions can be found at the IMA website. Basically to qualify for the Sterling Corporate Bond sector funds must be invested at least 80 per cent in bonds rated BBB- or above, Sterling High Yield is for funds with at least 50 per cent in debt below BBB- and Sterling Strategic has no bond-grade constraints. At any point in time the asset allocation of funds within the Sterling Strategic sector could theoretically place them in one of the other fixed interest sectors. The funds will however remain in the Sterling Strategic sector on these occasions since it will be the fund manager’s intention to retain the right to invest across the sterling fixed interest credit risk spectrum.

Indeed, strategic bond funds have grown in popularity in the last few years because of the very fact that they are given the flexibility to allocate assets between high yield bonds, investment grade corporate bonds and government bonds depending on where the manager feels there is value. The perceived wisdom is that government bonds tend to do well when inflation is low and the economy is weak, while the higher-risk high yield bonds prosper in a stable and growing economy.

When looking at bond funds it is also important to consider the Ucits III rules and how these are being used by the fund manager. From 1 September, for example, M&G has had the option to employ Ucits III powers across its bond fund range. Indeed, fund manager Richard Woolnough has already demonstrated the advantages of using Ucits III powers in his M&G Optimal Income Fund which launched in December 2006. This fund can use derivatives to take long and short positions and Mr Woolnough also uses credit default swaps as well as interest rate futures as appropriate to enhance returns.

In terms of an appropriate asset allocation for the risk that they are prepared to take many investors will find that including an element of fixed interest exposure in their portfolios will be beneficial. The challenge is deciding on the appropriate type and amount of fixed interest exposure to have in a portfolio, not least because recent collapses such as Lehman Brothers further highlight the significance of default risk. This is, of course, where an IFA with access to the appropriate analysis and tools comes in.

Andrew Gadd is head of research for the Lighthouse Group