Why corporate bonds make sense in active ETFs

Although interest rates are a bit higher in 2021, they're still very low historically, and it remains challenging for fixed-income investors to find dependable yield. Investment-grade corporate bonds are a popular choice for investors looking for incremental income over U.S. Treasuries without taking on too much credit risk in their portfolios. We think corporate bonds make sense within actively managed ETFs, especially for investors who want to potentially avoid the riskier areas of the market.

why-corporate-bonds-make-sense-in-active-etfs

We’re excited to join the fast-growing market for active exchange-traded funds (ETFs) as the portfolio managers of a new U.S. corporate bond ETF. There are more than 1,000 actively managed ETFs around the globe, and some of the oldest and largest active ETFs invest in bonds. This makes sense to us because we believe there are opportunities for active managers in fixed-income markets, including corporate bonds.

Global actively managed ETFs

Active fixed-income assets.

Source: ETFGI, as of 3/31/21.

Why corporate bonds now

With rates near historical lows and expectations for higher interest rates to negatively affect sectors such as U.S. Treasuries, corporate bonds have experienced significant global demand. While there's still uncertainty surrounding the COVID-19 pandemic, we remain positive on long-term economic fundamentals, particularly as we transition through the recovery phase. We expect that corporate bonds won't only benefit directly from an improved economic environment but also from robust global investor demand for yield.

Although inflation has been heating up lately, we don't believe it's a reason for corporate bond investors to head for the exits. Factors such as elevated unemployment levels, we believe, will keep higher inflation levels from extending long term. Also, the higher yield spreads of corporate bonds relative to Treasuries of similar duration suggest they stand a better chance of positive real yields, which adjust for inflation. For example, the Bloomberg U.S. Aggregate Bond Index has a yield of 1.44%, while the U.S. five-year Treasury note yields 0.80%.¹

Credit spreads: are corporate bonds expensive?

Credit spreads in corporate bonds—the difference in yields between corporate bonds and Treasuries of similar duration—have largely recovered after they widened sharply in the early stages of the COVID-19 pandemic. While spread tightening greatly benefited corporate bonds over the last 12 months, some investors have become concerned about current valuation levels.

Corporate credit spreads (%)

Corporate credit spreads in fixed-income ETFs.

Source: Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org/series/BAMLC0A0CM, 6/16/21.

While acknowledging that credit spreads are clearly low, we don't believe that they're automatically destined to widen significantly in the near term; in fact, there's precedent for credit spreads to remain rangebound near historical lows for extended periods, such as the environment from 2003 to 2007.

Notably, these extended periods of tight credit spreads correspond closely with periods of rising interest rates. Higher rates typically indicate a stronger economy, and combined with the U.S. Federal Reserve’s commitment to an accommodative monetary policy, we believe corporate bonds will continue to benefit from a favorable backdrop. Strong fundamentals and stable spreads suggest that corporate bonds may act defensively in a rising-rate environment, helping to better protect fixed-income investors relative to more interest rate-sensitive sectors such as U.S. Treasuries. 

Our bottom-up approach to an active corporate bond ETF

We believe rigorous fundamental credit research can help active managers outperform passive corporate bond index ETFs. Bond indexes aren't equal weighted, and by taking an index approach, investors are gaining large exposures to the most indebted issuers in the market. Active managers are able to be selective, concentrating on the most opportunistic sectors in the corporate bond market.

For corporate bonds, we take an active, bottom-up approach focused on fundamental analysis and relative value, relying heavily on sector allocation and security selection to generate value. Although we don't attempt to time the movement of interest rates, we generally take a targeted approach to maturity selection based on expected changes in the shape of the yield curve. We believe our bottom-up approach is more consistent and repeatable across market environments.

When looking at the overall corporate bond market, we start with macro themes and attempt to identify the most attractive sectors in this market based on our economic and business cycle outlook. Sector overweights and underweights are an important source of added value, and our nimble approach enables us to use our current outlook to take advantage of sector opportunities with positive catalysts for outperformance. Active, bottom-up security selection within each sector is key, with our fundamental analysis helping to identify issuers with the best relative value while simultaneously avoiding riskier ones. Portfolio construction and risk management are paramount, with the goal of ensuring that exposures are highly diversified and liquid.

Putting it all together, we believe an active approach to corporate bonds makes sense, and we’re excited to make our strategy available to more investors in the ETF format.

 

1 Bloomberg, U.S. Department of the Treasury, as of 8/24/21.

The Bloomberg U.S. Aggregate Bond Index tracks the performance of U.S. investment-grade bonds in government, asset-backed, and corporate debt markets. It is not possible to invest directly in an index.