August 10, 2012 / By RICHARD BARLEY / WSJ

Crisis, what crisis? Despite political and economic turmoil, Europe's corporate bond market is doing just fine. Investment-grade euro-denominated bonds have returned 8.9% year to date, a rate of return more usually seen on "junk" debt. The search for yield means the rally in credit markets can continue. But there are growing reasons for caution.

It's easy to understand why investors are piling into corporate bonds. Yields on corporate debt are a multiple of those available from safe-haven governments: While five-year German bunds yield just 0.35%, five-to-seven year industrial bonds yield 2.43%, according to Barclays BARC.LN +2.49% . Many companies have preserved their balance-sheet strength and hoarded cash. Continued intervention by the authorities to stave off calamity—including the European Central Bank's apparent promise to buy bonds of struggling euro-zone nations—has buoyed the market. Overall spreads to government bonds look wide by historical standards, at just over two percentage points, compared with half a point pre-crisis.

But there are good reasons for spreads to be wide. Fundamentally, the economic backdrop in Europe is poor, with even mighty Germany suffering. If Spain and Italy do ask for aid, their ratings could be downgraded, potentially into the "junk" category. That could drag corporate bond ratings lower too. There are €200 billion ($246.12 billion) of investment-grade Spanish and Italian corporate bonds out there, Bank of America BAC -0.26% Merrill Lynch notes, far too much for the high-yield market to absorb easily.

Technically, too, there are risks. Secondary-market liquidity is extremely poor, partly because investment banks have retreated from market-making due to higher capital requirements. Numbers for Europe are hard to come by, but in the U.S., primary dealers' holdings of corporate bonds have collapsed from more than $200 billion in 2007 to $42 billion now, New York Federal Reserve data show. That means investors are limited to what the new-issue market throws their way. Given the rally in Spanish and Italian debt, issuance in September could be dominated by offerings from riskier countries.

The fear is that corporate credit has become the consensus safe-haven trade, driven by a hunger for yield. If that consensus changes, then the rush for the exits could be nasty.