The hybrid approach to uncovering opportunities in credit
Merging traditional research with a machine-driven process can capture gains in inefficient corporate bond markets
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Credit markets are highly complex. That complexity can lead to inefficiency and a mispricing of individual bonds compared to their fair value. It is this mispricing that provides active investors opportunity to add additional return over the market.
A hybrid approach – combining the computational power of “systematic” investing alongside insights from fundamental research – can help generate returns from otherwise overlooked, and undervalued, parts of the market. It also enables a strong risk management framework that aims to minimise potential downside.
The sheer scale and range of opportunities within the multi trillion dollar global investment grade corporate bond market makes this asset class particularly well-suited to this approach.
Understanding what’s driving credit valuations is key to determining their value
Multiple factors determine a price of a corporate bond at any point in time. Some are well understood, and therefore adequately factored into corporate bond pricing, but our analysis suggests that as much as 30% is ineffectively explained. It’s this overlooked part of the market which drives the most significant potential for mispricing of a bond versus its fair value – and the greatest opportunity to generate additional return.
Put simply, if you purely invest where the market is focused, you'll earn around market-level returns. Whereas targeting overlooked areas can generate returns over and above that, purely through bond selection.
Interested in an active approach that targets corporate bond market inefficiencies? Learn more about Schroder Global Investment Grade Corporate Bond Active UCITS ETF.
Chart 1: Optimising returns by identifying underexplored segments of the market
1 Credit ratings are an indication of an issuer’s credit worthiness 2 Analyst projections on fundamental factors such as interest coverage, margins etc.
Source: Schroders, September 2025. For illustrative purposes only and not a recommendation to buy or sell.
A corporate’s fundamentals fall into the “often overlooked” segment, with factors such as a company’s individual profit margins, leverage or financial ratios causing certain bonds to behave differently within the same sector. Incorporating credit analysts’ fundamental projections can therefore uncover a fair value estimate which differs to that of the market – and therefore to the price of a bond.
Once the bond’s fair value is determined we can buy the undervalued bond (sized appropriately), selling it once it’s achieved its target price (i.e. around our view of fair value). We’ve illustrated this in the chart below where each blue dot represents the spread of an individual bond and each green dot is its assumed fair value. We simply sell the bond when these two dots align and rotate into a bond which offers a better opportunity.
Chart 2: Systematic approach identifies undervalued bond and holds until fair value is reached
Source: Schroders. For illustrative purposes only, not a recommendation to buy or sell. Spread is the difference in yield between a corporate bond and a risk-free bond. OAS is the spread after adjusting for options that can change the bond’s payments.
A rules-based, “systematic” approach can uncover undervalued opportunities
To achieve this at scale, it makes sense to incorporate a systematic approach which can use pre-defined rules and algorithms to identify undervalued bonds to capture returns.
We believe that there are three main advantages to this approach:
- The data processing power of a machine far outweighs that of a human. A systematic framework can evaluate every single bond in the global corporate bond investment universe (that’s over 12,000 US dollar- and euro-denominated issues) on a daily basis against a derived ‘fair value’ and it can achieve this in less than 25 minutes. This is not just at an issuer level but right down to the characteristics of each individual bond. The ability to cover the whole market massively increases the potential number of alpha-generating opportunities.
- A clear framework. The investment process is coded from the start via the algorithms that feed into the model. Because it works purely on a disciplined fair value approach there’s no unexpected surprises when it comes to an end portfolio – the model ensures close to neutrality when it comes to both market and interest rate risk. Already, this level of transparency goes beyond that of traditional approaches.
- Removal of bias. The rules-enhanced framework removes behavioural risks. A machine can be more disciplined than a human when it comes to sticking to pre-defined rules. There’s no ‘best idea’ to become emotionally attached to – a bond is simply sold when it reaches its perceived fair value.
When a machine needs a human touch
While there are benefits to systematic, machine-based approaches, there are also flaws. Even highly sophisticated processes aren’t infallible and if the valuation of a bond looks too good to be true, it may well be…or at least require further investigation.
Unlike a machine-driven system, a fundamental approach can identify idiosyncratic risk – the type of event that can’t be learnt from history. Examples would be a significant risk event specific to a single issuing corporate, such as a merger or potential litigation.
The job of our credit analysts is to delve into anything that can’t be accounted for by a purely machine-driven approach. Their insights can help avoid risk or identify an undervalued opportunity.
The chart below shows an example where fundamental analysis identified risks prior to these becoming priced in by markets. This was a period when the higher-for-longer interest rate environment made this issuer particularly vulnerable compared to other banks because of its relatively higher exposure to the commercial real estate market.
Chart 3: Deutsche Pfandbriefbank: incorporating fundamental analysis to mitigate risk
Source: Schroders. For illustrative purposes only and not a recommendation to buy or sell.
Incorporating the best of both worlds
Our hybrid approach, merging systematic tools with fundamental research, allows us to screen the entire global corporate bond universe and combine this with valuable fundamental research.
This active approach can adapt to changing market dynamics in a way that passive strategies cannot. It offers the granularity and sophistication necessary to fully benefit from the advantages of good intra-sector diversification, where two bonds from the same sector may react differently to the same market events.
The outcome is the construction of a balanced portfolio that can outperform the market in any environment, purely through bond selection without taking additional market risk (i.e. market risk is neutral).
The hybrid approach combines the strengths of both systematic and fundamental analysis – creating a sum greater than the parts.
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