Should the market start to believe that the European Central Bank cannot or won't undertake sovereign bond purchases, then there could be problems. Agence France-Presse/Getty Images
 
 
Investors face a dilemma: should they take comfort from safety in numbers, or be nervous about following the herd? Rising risks to growth and a less supportive stance from central banks could test a number of popular trades: the herd could turn.
 
Ultra-loose monetary policy has pushed investors en masse to take risk, particularly in fixed-income markets. That has led to some trades becoming “crowded,” and thus potentially vulnerable to sharp reversals if the assumptions underlying them prove false. Europe looks riskier than other regions on this score since the European Central Bank’s efforts to boost growth and inflation are falling short. Meanwhile, the U.S. Federal Reserve is finally winding down its bond purchases and yields are skinny. The factors that have propped up risk appetite are waning.
 
But investors have accumulated hefty positions. A recent survey of European investment-grade bond investors by J.P. Morgan Chase & Co shows they hold the largest long positions in the survey’s 13-year history; they also hold very low cash balances and have been buying riskier instruments to boost returns.
 
Meanwhile, positioning data from Citigroup shows investors have bet heavily on Irish and Spanish government bonds, while positioning in German Bunds and U.S. Treasurys is more balanced.
 
The European high-yield bond market has already felt the impact of a reversal, sparked in part by concerns about U.S. rates and in part by idiosyncratic problems like the collapse of U.K. mobile-phone retail chain Phones4u. Returns have been dented as a result. A renewed recession in the eurozone could lead to further outflows from high-yield bonds.
 
Other parts of the market have held up better. But that might make investors eager to pocket some of the outsize returns that have been generated before the year ends. Southern European bonds have been star performers again: Italian bonds are up 12.3%, Spanish 14% and Portuguese debt 18.9%, according to Barclays indexes. But Citigroup’s data shows that long-term institutional investors stopped buying in September; the baton has been taken up by hedge funds, who may prove more flighty. Hopes that the ECB will buy sovereign bonds may be sustaining demand. But if the market were to start to believe that the ECB cannot or won't undertake such purchases, then there could be problems.
 
The big concern, which has yet to be tested in earnest, is that fixed-income markets will be unable to cope with outflows of any size as regulation has crimped the ability of banks to trade bonds.
 
So far, betting against central banks has been unwise: if markets have pulled back, it has been a good idea to buy at lower prices as policy makers have acted to reassure investors. But with the growth outlook rocky and central-bank support diminishing, that might no longer be true.
 
Riding with the herd has been profitable. But when the herd turns, investors should beware getting trampled.