Crowded trades no more

China/EM fears, idiosyncratic risk, poor market liquidity and no inflows. All have conspired to drive the biggest risk reduction by investment-grade accounts since the Greek crisis in mid- 2011. Credit overweights have fallen to just 9% now, from 32% in July, and from a cycle high of over 50% in May this year. And CDS hedging looks to have been the big facilitator of investor risk reduction lately. But with longs in credit back at April 2012 levels, technicals have become more supportive for investment-grade spreads in October.

The illusion of big cash

Not only are crowded longs down, but cash levels are high, and cash is now investors’ biggest overweight. The average cash level for IG investors has jumped from 4.9% to 6.2%, close to the highs of 6.5% seen in late 2011. This feels supportive for credit spreads as well. But clients highlight in October’s survey that their big cash holdings are to help manage potential outflows, given challenging secondary market liquidity. Note that investment-grade accounts have seen no net inflows over the last 3m, ending a 3.5yr trend of constant inflows into European credit.

Major declines in high-beta exposure

Long covering has been rife in high-beta credit sectors. Big declines in overweights have been seen in sub insurance (from 34% overweight to 4% underweight), banks T1/AT1 (18% overweight to 6% underweight), LT2 (48% overweight to 13% overweight) and corporate hybrids (34% overweight to flat). Auto positions, understandably, have seen a massive reversal (from 8% overweight to 53% underweight, the biggest decline ever seen). By contrast, sectors where positioning has been much more stable have been senior banks (clients say "TLAC widening overdone"), and telecoms and utilities (clients say "still a risk that the ECB buys corporate bonds").

Dreading that QE(2) feeling…

On sentiment, credit investors see little reason for joy if the ECB extends their current QE programme (BofAML expect a QE extension this month). The majority of investors in our survey think extending QE will have a minimal impact on asset markets as central banks have already gone "too far down the rabbit hole" with monetary policy. Only 31% of investment-grade and 25% of high-yield investors surveyed think that QE2 will be successful in driving asset prices up.

…but longing for a China bounce

China (EM) slowdown has become by far the greatest concern for credit investors now. Thus, stability in the China data is seen as one of the strongest catalysts for a rally in credit, especially among high-yield investors. Investment-grade accounts believe ECB corporate bond buying will be the most supportive of a rally, however.

Contrarian trades

Contrarians should look to be long credit (3rd smallest overweight in credit since the start of 2009), long LT2s (2nd biggest drop in LT2 overweights ever in October), long corporate hybrids (2nd biggest drop in overweight as well), long sub insurance (first underweight in the sector since June 2012) and long autos after the sector exodus.