Investors in euro-denominated corporate bonds have been richly rewarded. As the European Central Bank (ECB) pushed interest rates into negative territory and introduced corporate bonds into the universe of assets it is buying, bond prices, which move inversely to yields, went higher and higher.
Investors still can squeeze some gains from this asset class, but the party looks increasingly past its zenith, so it takes some skill to navigate from here.
It is true that things still are looking good in Europe, and especially the eurozone; manufacturing PMI hit a six-year high in September, inflation is at a very tame 1.5% and unemployment is falling in some of the countries that were hit hardest by the crisis.
European bonds have outperformed other asset classes this year, as the ECB bond purchases pushed yields further down across all maturities and credit ratings. Strategists at Societe Generale say that investors in sovereign bonds should increase their overweight positions in European periphery bonds versus those of core countries such as Germany because Bunds are likely to be hurt more in the event of faster-than-expected tapering by the ECB.
Not that there is a big danger of that happening. ECB President Mario Draghi repeatedly has made clear that the central bank will take a very gradual approach to winding down its quantitative easing stimulus.
But even the hint at "normalization" by central banks has moved yields upward, and it is possible that they will continue rising. Because of the strong performance of European corporate bonds this year, the strategists at Societe Generale say they are now overvalued and tend to favour U.S. and emerging markets corporate debt.
Nevertheless, there is still money to be made in European fixed income. Investors willing to take on some additional risk could see some good returns by moving into lower-rated corporate bonds and riskier structures. Contingent convertible bonds, used by banks to fulfil their Basel capital buffer obligations, have outperformed all other corporate bonds since June, according to the strategists.
They expect higher-risk corporate bonds, especially those issued by financial sector companies, to outperform for a while. Investment-grade corporate debt could be hurt by speculation about when the ECB will end its purchases of corporate bonds, because this is the asset class that makes up the program's universe.
Besides that, volatility has been very low, contributing to higher appetite for risk. "Low realised volatility in general is pushing investors into more risky assets, and European credit is seeing exactly the same trend," Societe Generale's credit strategists Guy Stear and Juan Valencia wrote in their latest research.
Looking to next year, clouds are gathering over the corporate debt horizon. First, as central banks normalize monetary policy and interest rates move slightly higher, investors will shift at least some of their cash into sovereign bonds, which are considered to be safer than corporate bonds.
Second, as global growth inevitably will slow at some point, cash flows will slow down as well. People are unlikely to save in their pensions or investment accounts as much if their jobs are not as secure as they used to.
The third and perhaps most important risk mentioned by Societe Generale's strategists for next year comes from rising leverage. They show that median debt-to-equity ratios (weighted by market cap) have been increasing since 2010, reaching 35% currently for companies in the euro-denominated debt universe. This is broadly the same level as the peak hit in 2001.
While that is mainly due to higher-leveraged North American and U.K. companies that opportunistically issued debt in euros to take advantage of the ECB's corporate bond purchases, stripping those out shows a debt-to-equity ratio of about 32%.
Still, these are things to worry about next year. Over the remainder of this year, the strategists believe that spreads to benchmarks could retest the highs of mid-2014, squeezing another small increase in corporate bond prices.