Fund managers warn on corporate bonds Europe's corporate bond rally may be running out of steam. Since the European Central Bank hinted at a fresh bond-buying programme in late July to lessen risk of a eurozone break-up, investors have poured money into corporate bonds. Those along for the ride have been handsomely rewarded. Returns for European corporate bonds have been 11 per cent on average for the year to date, second only in the past decade or more to the returns seen in 2009, according to the Barclays Euro Corporate Bond index. Yields, which move inversely to prices, have hit record lows for Europe in "junk" bonds and investment grade. But many major fund managers are starting to warn that the latest rally could be looking a little stretched. Some are merely complaining that it will be hard for them to find much upside in 2013, while others are arguing that a correction could be due. Investors point to the multiple records that have been broken in recent months as a worrying sign. Nestlé, for example, last week broke the record for the lowest ever coupon on a four-year bond, borrowing at 0.75 per cent. The seven-year, 10-year, 12-year and 15-year records have also been broken recently. Other deals that have caught the attention of wary credit investors include Procter & Gamble, which priced a €1bn, 10-year bond in August at 25 basis points over mid-swaps, the benchmark European funding rate. Siemens sold a two-year and seven-year bond at mid-swaps minus 10bp and plus 20bp, respectively, to fund a share buyback. "We think that in parts of the credit market there is a bubble being formed as investors search for yield," said Matt Rubin, director of investment strategy at Neuberger Berman. "Many investors are underestimating the risks in what are perceived to be "safe" asset classes." Many are arguing that even the junk bond market, which has benefited most from central bank action pushing investors towards riskier assets, is starting to look like less good value. The yields on the best-rated junk bonds have fallen more than a full percentage point from 6.9 per cent in June to 5.4 per cent this week, according to the JPMorgan European high yield index. "High yield has had a very good run and you have either been in this game or you haven't now," said Owen Murfin, who manages global and European corporate bond fixed income portfolios for BlackRock. We are being increasingly selective in what we buy now. The rally has prompted some to argue that equities - particularly in Europe - look more attractive than corporate bonds. "Our feeling is that it is time to move into equities," said Mr Rubin. Lending weight to that argument is the fact that the gap between dividend yields on European stocks and corporate bond yields is now higher than at any time since 1999. Nearly half the companies in the Stoxx Europe 600 index have dividend yields above the aggregate credit yield, according to research from Goldman Sachs. "Investors might look for credit-to-equity replacement opportunities to pick up higher yields," said Christian Mueller-Glissmann, an analyst at Goldman, adding that the two asset classes are not directly comparable as equities have more risks. [Still,] we think equities might outperform credit in the medium term. Valentijn van Nieuwenhuijzen, head of strategy at ING Investment Management, shares that view: "While it may be a little too early to make the move, at some point in the fourth quarter a shift from credit to equities seems to make sense," he said. The flipside to this bearish argument on credit is first the fact that yields on European corporate bonds relative to those of German Bunds are still far from historic lows. This makes the asset class look better value on a relative basis than absolute coupon levels or a comparison with equity dividends might imply. The second is that the long-term future for corporate bonds hinges mainly on the future strength of the European economy. If Europe remains in a low-growth, low-inflation and low interest-rate environment for the foreseeable future then corporate bonds could well continue to strengthen. Nick Gartside, chief investment officer for international fixed income at JPMorgan Asset Management, argues that far from European corporates being overvalued, spreads over Bunds are likely to halve over the coming years. But he takes as his base scenario that Europe is entering a Japan-style decade of economic stagnation. "It may be that there are some credits which have tightened so much recently that there is not much further to go but, on average, corporate spreads are still likely to halve in the next few years, given that we are entering a period of protracted low growth and low rates in Europe," he said. In the short term, though, after such a strong rally, credit fund managers are worrying that at the very least they are unlikely to see these kinds of returns again any time soon. The incessant tightening trend is beginning to irk a few. We're looking ahead with some apprehension as to how to generate some performance in 2013," said Suki Mann, head of credit strategy at Société Générale.