It's not often bonds get me excited, but when fund managers are talking about a once-in-a- generation investment opportunity it's worth taking notice. Especially as they are not normally an excitable bunch.

Bonds are traditionally the geeky older brother of the investment world. They offer a steady fixed return and modest growth prospects, while racy equities get all the attention. While shares are commented upon daily, bonds merit only a passing mention in the financial pages.

The credit crunch has changed all that. Following the collapse of the US investment bank Bear Stearns and Britain's Northern Rock, the prices of bonds issued by “blue chip” institutions have been hammered, pushing up yields to their highest level for 20 years.

Yields could go even higher, of course, if financial institutions have more skeletons in their closets (yields rise when prices fall). However, as the Bank of England indicated last week, credit, including bonds, has gone from being grossly overpriced last summer to underpriced now. I would think the Bank is one of the best buy signals out there.

You would expect yields on investment-grade bonds (the highest-quality bonds, rated BBB or more by the ratings agencies) to be around the economy's growth rate - or about 4% - but they are now paying about 7%, and some bonds issued by Britain's banks yield even more.

This means bonds are cheaper than they were between 1998 and 2002 during the time of the Long Term Capital Management hedge fund's collapse, and the Enron and Worldcom crises.

Historically, the average default rate for UK corporate bonds with a BBB rating or above has been 0.8% and the worst 2.4%, but the default rate implied by today's prices is an apocalyptic 19%, according to an analysis by Invesco Perpetual.

This would require the sort of financial meltdown that has not been seen since at least the 1970s. So when Halifax Bank of Scotland (HBOS) asked its investors to buy more shares last week as part of its £4 billion rights issue, I would be tempted to look at its bonds instead.

HBOS has a bond whose yield at issue was 9.375% until 2021. All bonds have a nominal value of £100, so you would have received £9.38 a year for the next 13 years for every £100 bond, plus your capital back at the end of the term. That's guaranteed, unless Britain's biggest mortgage lender goes bust - and even the grizzliest bears must accept that is unlikely.

Even if Armageddon did happen, Northern Rock has shown that the government would step in to guarantee depositors' cash - and that includes holders of investment-grade bonds.

Once issued, bonds are traded and their value can fluctuate. The smart money has already moved into the market, so they are not looking quite as cheap as they were. The £100 HBOS bond above now costs £119, giving you a yield of 7.9%. Take into account the fact that you will suffer a £19 loss at maturity, set against the £121.88 you will receive, and your yield falls to 6.7%. Even the Icelandic banks will only offer 7% on their savings accounts for one year.

Bond fund managers are so convinced the worst is over that they are even looking at - whisper this - mortgage-backed securities. These are the investments that sparked the credit crunch in the first place. Banks parcelled up their mortgage debt into special vehicles and then sold them on to other investors. Prices have, understandably, been hammered, but if the Bank of England is right that the sell-off has been overdone, this could be an historic buying opportunity.

Take Gracechurch, a vehicle underpinnned by a portfolio of Barclays mortgages. Although it was set up in 2005, the home loans in the portfolio are up to nine years old and are worth, on average, only 30% of the value of the properties against which they are secured. In other words, house prices would have to fall 70% before borrowers would be in negative equity.

Before the Bank's comments, Gracechurch was yielding 7.5%, according to Ian Spreadbury of Fidelity's Sterling Bond fund, who snapped up some for his portfolio. By the end of last week, prices had rallied sharply and the yield was down to 5.7% - not such a good buy, but Spreadbury says he is happy to hold for the long term.

So the next question: what to buy now? While the industry pushes its bond funds, wealthier investors are generally advised to buy individual bonds. The latter offer a fixed rate of return and your capital back if you hold the bonds to maturity, and the company doesn't go bust.

Bond funds, on the other hand, invest in a broad portfolio that is not always held to maturity, so there is a risk that you will get back less than what you paid.

The problem with individual bonds, though, is that you need to invest at least £1,000 in each. Advisers say you would need at least £10,000 before individual bonds are worthwhile, after dealing fees. And ideally you want bonds that are trading “below par” (below face value). If above, you will automatically suffer a capital loss on maturity.

For most investors, therefore, a bond fund is the better option. Nigel Parsons at adviser Bestinvest likes New Star's Sterling Bond fund, which has a tasty yield of 5.7% and is packed full of bank and building-society bonds, if you really want to bet on the worst of the credit crunch being over. One of its biggest holdings is in a bond issued by Bradford & Bingley with a yield of 5.625% until 2013.

A little higher up the risk scale is Henderson Strategic Bond with a yield of 6.4%. Again, it is stuffed with bank bonds issued by HSBC, HBOS and Barclays.

Always invest in bonds within an Isa - it's more tax efficient than putting equity funds inside the wrapper if you're a higher- rate taxpayer. That's because bond interest is taxed at 40% outside an Isa, whereas an equity investor would pay just 32.5% on dividends from shares.

Kathryn Cooper is editor of The Sunday Times Money section

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