Unpacking the potential of systematic credit investing in ETFs

Against a global backdrop of elevated inflation levels and a higher-for-longer interest rate environment, investors are now benefiting through the higher yields on offer from companies issuing bonds. We believe this is changing the role of corporate bonds in balanced portfolios – for example through bond ETFs - and explain why a systematic approach to corporate bond investing can offer efficiencies for investors.

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In recent years, interest rates have been at record lows, although this has changed noticeably since late 2022. High-quality bonds have become much more attractive for investors again. The crucial question here is: Will inflation remain high, as some data suggests, and could yields rise even further in the near future?

There are different assessments of this in the market. Some market participants expect further interest rate hikes. But the pace and scope of monetary tightening is already unprecedented. The measures are likely to further dampen inflation, as they have a weakening effect on economic activity. In addition, there is an effect from the pandemic period. Many people spent less money then. This is now strengthening demand but this will not last indefinitely.

Lessons from the Global Financial Crisis

Since the Global Financial Crisis of 2007/2008, many countries and also companies have been groaning under an increased debt burden. The pandemic has exacerbated this. The central banks have no choice but to adjust their policies to avoid another potential economic crash.

We believe this means central banks will find it difficult to move real interest rates far into positive territory, especially over an extended period of time. The collapse of Silicon Valley Bank underlined this in March. No sooner was the banking system under stress than interest rate expectations in the market fell.

Behind this is a clear calculation on the part of investors: the central banks will take countermeasures when higher interest rates become more noticeable in the economy. What would falling long-term interest rate expectations mean for corporate bonds, for example, for the total returns of high-quality securities, i.e., investment-grade bonds? Typically, such securities would benefit given their maturities.

What about defaults?

Persistent inflation and prolonged increases in interest rates could have negative impacts on companies’ sales, profits and cash inflows.

What happens if companies cannot service their bonds as a result? In other words, if they default on their payments?

The fact is that companies’ financial ratios have held up quite well overall so far. This is shown, for example, by a look at gross debt and margins. This is partly due to measures taken during the pandemic. In addition, many financial managers have already prepared for a more difficult financing environment.

This is also evidenced by the latest Fidelity analyst survey which found companies are currently strengthening their balance sheets.

For example, they are increasing cash balance es, strengthening their liquidity and reducing their debt burden.

A systematic approach to investing in corporate bonds

How can one invest in corporate bonds in a timely manner and reduce risks beyond the pure “credit risk” as much as possible, i.e., the possibility of default?

One way to do this is through an analytics-based, active, and systematic multi-factor approach. Fidelity has a long tradition of putting bonds through their paces. We can analyse our own extensive information in a targeted way. The database is constantly updated worldwide. New fundamental insights? A change in market sentiment? Signals from individual bond issuers?

We can systematically take such findings into account. We can also take a close look at individual corporate bonds. We use our own application for portfolio construction: the “Optimus Tool”. With it, we improve portfolios under clear aspects such as quality, liquidity and transaction costs.

This approach can help to avoid undesired deviations from the benchmark. This is true, for example, when it comes to average maturity (“duration risk”) or the risk of default (“credit risk”). It can also help to achieve a suitable spread in terms of geography and currencies.

In doing so, we pursue a clear goal: an excess return compared to the benchmark that results from the selection of issuers and securities. And not through other, “unplanned” factors or distortions. In an environment characterised by uncertainty, such effects could become even more pronounced. Ultimately, we want to identify the bonds from a broad investment universe that we believe offer particularly good returns.

The whole approach is precise, risk-controlled and cost-conscious.

Best-in-class ‘Article 9’ sustainability credentials

High standards of corporate responsibility generally make good business sense, as they can help protect capital and enhance investment returns.

Consequently, we integrate sustainability assessments into our systematic strategies primarily through Fidelity’s proprietary ESG Rating framework. Under this framework, Fidelity’s bottom-up fundamental analysts around the world rate companies and issuers’ sustainability characteristics holistically, based on key performance indicators specific to over a hundred unique individual sub-sectors. This provides granular ESG data that our systematic processes can harness to target specific investment outcomes.

Sustainable bond ETFs

Some of Fidelity’s sustainable bond ETFs go particularly far: they meet the requirements of Article 9 of the EU Sustainable Finance Disclosure Regulation (SFDR). For these ETFs, sustainability analysis is an integral part of the investment process undertaken to invest in “sustainable investments”. These investments do not cause significant harm within the meaning of the EU taxonomy (“Do No Significant Harm”). In addition, they pursue a sustainable investment objective and aim to reduce the carbon footprint.

This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full magazine, click here.

Important information 

This information is for investment professionals only and should not be relied upon by private investors. The value of investments and the income from them can go down as well as up and investors may not get back the amount originally invested. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. Investments in emerging markets can be more volatile than other more developed markets. Fidelity ETFs can use financial derivative instruments which may result in increased gains or losses within the fund. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the Fund investing in them. Due to the greater possibility of default an investment in a corporate bond is generally less secure than an investment in government bonds. A focus on securities which maintain strong environmental, social and governance (‘ESG’) credentials may result in a return that at times compares unfavourably to similar products without such focus. No representation nor warranty is made with respect to the fairness, accuracy or completeness of such credentials. The status of a security‘s ESG credentials can change over time. Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority and Financial Administration Services Limited, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0923/382286/SSO/NA 

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