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Brad Bugg is head of fixed interest with Ibbotson Associates.

Australian bonds returned just over 12 per cent in 2011, leaving many investors contemplating what they could expect from Australian bonds in 2012.

The simple answer is 2012 will again be volatile, with returns likely falling short of those seen in 2011, but by how much is the more difficult question. Returns on Australian bonds in 2011 were driven by yields on the 10-year government bond, falling from 5.57 per cent at the start of the year to 3.67 per cent, a level below the 4 per cent lows seen at the height of the 2008 financial crisis.

While the Australian economy has certainly softened over the course of the year, the primary driver of this drop in yields has been the strong investor demand for Australian government bonds. This demand has been spurred by increasing concerns in regard to the debt burdens of traditional safe havens like Europe and to a lesser extent the United States.

As a consequence we have seen a growing perception that Australia is one of the few "true AAAs" remaining on the global stage, leading to international investors seeking out Australian government bonds for the defensive part of their portfolio.

So as we enter 2012 this strong investor demand is likely to underpin Australia's historically low yields, and should it persist, Australian bonds are expected to have another relatively strong year and see returns in excess of their 5 per cent long-term average.

However, we are very wary of the current level of Australian government yields and see little scope for yields to fall on the scale of that seen in 2011 given their near 40-year lows.

Further, from a standalone fundamental basis, while we have seen the Reserve Bank of Australia recently scale back its medium-term expectations, growth and inflation are likely to still come in above 2.5 per cent in the next couple of years. Such an outcome makes the current 10-year bond yield of about 3.8 per cent look somewhat expensive, in our view.

Accordingly, we are cautious towards the medium to long-term outlook for Australian government bonds, particularly in the event of improved global risk sentiment.

This is despite Australia retaining its good standing among other governments around the world, but fear that in more buoyant markets investors will focus on Australia's better growth prospects and potential for higher inflation.

Such a scenario is likely to see yields push higher, giving rise to negative returns from government bonds just like in the second half of 2009 following the 2008 financial crisis.

The problem, of course, is that given the volatility of markets and the scale of the problems in Europe and the US, global risk sentiment could actually get worse before it gets better, prolonging such a sell down.

This could well mean Australian government bonds continue to perform well in the first half of 2012, before experiencing a difficult second half of the year. At this point, investors may look to consider rotating into more corporate and composite bond-oriented strategies where increasing opportunities are beginning to present themselves and are likely to perform significantly better than government bonds.

These opportunities have arisen as recent credit spread widening for a number of Australian companies looks to be overdone relative to the increased risk they might face from the prospect of weaker global growth.

Making such a shift is likely to see a repeat of the return scenarios witnessed in 2009 and 2010 where corporate and composite bond strategies did better than government bonds as sentiment and the economic outlook improved.

It should be highlighted, however, that returns are still likely to fall short of those seen in 2011, but such a shift should help investors achieve a more consistent income stream, while also better protecting their underlying capital.