'Why interest rates could go up in October'

But the important question for us is not just when will rates start to increase, but how far will they actually rise? An investor in bonds will generally want to reduce their exposure in a rising interest rate environment. Therefore, a bond manager aims to have fewer of those assets more seriously exposed to the risk of rising interest rates when rates are low and looking likely to rise. The reverse, of course, applies when interest rates are higher and the signs are that they could be cut.

At the start of 2013, we were very concerned about the potential for a rate rise as we thought the UK economy was far stronger than the market consensus.

Over 2013 the strong economic data increased the probability of rate rises, and given its sensitivity to predictions, there was a sell off in the bond market.

But as prices continued to fall, with the bond market factoring in good economic news (bad for bonds), we slowly bought back in. However, we are still generally wary of taking too much interest rate risk as we still believe the outlook for the UK economy is slightly better than the market consensus.

Given economic strength, the current cautious nature of the Bank of England, and the electoral cycle, the window for rates going up looks to be between October 2014 and February 2015.

However, when rate rises do eventually happen there will not necessarily be a big sell off in bonds; a lot of the news will already be priced in.

We also believe that a naturally low inflation world, driven by globalisation, technological change and a flexible labour market, means there is a limit to the inflation potential of the UK economy.

The extent of the bear market in bonds, when rates officially rise, should therefore be dampened by the market’s forward looking nature and the UK’s low long-term inflation outlook.

Richard Woolnough is fund manager of the M&G Optimal Income fund

more