Let's start by clarifying terms. When you're talking about keyword ad links, you're talking about the contextual pop-up ads that I run here on this site.

Through Kontera and competing advertising services the ad network automatically creates linked words within your blog entry that produce pop-up ads that, when clicked, generate revenue, right?

These are implemented by simply adding a single line of JavaScript to the bottom of each page on the site which you can identify by doing a "View Source" and (typically) scrolling to the bottom of the page. If you did that here, you'd see:

I will say that it is confusing for visitors and can be difficult to differentiate between legitimate URL links to external sites (like the screen capture immediately below: maybe I did have a link for the word "system") and those that are actually adverts. Remember:

    Bad experience = unhappy visitors = not a customer.

Further, there's a contextual issue too that can cause some level of cognitive dissonance. Above, the article is about twitter and other lightweight social networking tools, but the advertisement is for Sun's open source Unix operating system. Not really related and not very well targeted. This can also confuse readers.

However, I don't think that the use of contextual advertising affects search engine results because search engines generally don't interpret and "apply" javascript includes. They aren't rendering the page, just trying to figure out the keywords and links thereon. So probably Googlebot (etc) never even see any of these contextual advertising links.

Now if we look at on-page credibility that's another issue entirely! The question is: do ads dilute credibility? At some level I think the answer has to be "yes", but only when there are too many advertisements.

Let's look at mainstream media for an example. Is a commentary or editorial in the New York Times, Washington Post or Wall Street Journal adversely impacted by the fact that those newspapers also accept advertising? I don't think so. On the other hand, if the ratio of content to ads goes too far askew, then we have advertorials or infomercials. That's one end of the continuum, with the other end being zero ads, the Consumer Reports model.

I did remove all advertising from my business blog almost a year ago when I decided that having zero ads gave me a small credibility boost, but I have ads on other weblogs, and this blog, my flagship site focused on tech support, has quite a lot of advertising, though less than competitive blogs in the tech space.

If your client wants to have ad-like links to other areas, pages or products, then I would suggest having them be overtly not advertisements might be the most beneficial. It makes a subtle statement that the site is advertising (e.g., bias) free. It might not be true :-) but it's a good message and there are a number of other ways to gain benefit from internal linking without being spammy.

Hope that helps clarify things. It'll be useful for other people to add their perspective in the comments too (hint hint).