Henderson Diversified Income Trust Fund Manager Commentary – Q2 2022

John Pattullo, Jenna Barnard and Nicholas Ware, Portfolio Managers of Henderson Diversified Income Trust, provide an update on the Trust highlighting the key drivers of performance over the quarter, the challenges fixed income investors are facing, recent portfolio activity, and provide their outlook for bond markets over the coming months.

Macro backdrop

It has been a tough first half of the year for financial markets. The second quarter saw a pivot away from higher inflation to weaker global growth and imminent recession risk as the dominant market driver. Developed world government bonds were hit as markets priced in significant additional increases in interest rates. Markets are now expecting interest rates to rise to 3.3% in the US, 3% in the UK and 1.6% in the eurozone. This also impacted equities and credit markets and by the end of the quarter it was only the US dollar and some commodities (such as oil) that had done well.

The central bank interest rate hike trajectory remained one of the dominant market narratives, helped by US Consumer Price Index (CPI) data which delivered yet another surprise in May as it rose to a new 40-year high of 8.6%.¹ Hopes of peak inflation and peak central bank hawkishness faded and gave way to a calls for a more aggressive rate hiking path from the US Federal Reserve (Fed). The Fed duly delivered with a 75 basis point (bps) rate hike in June. The Swiss national bank followed with a surprise rate hike of 50bps, and the market tried to take on the Bank of Japan's yield curve control in a historic week for the rates market. The second week of June saw the US 10-year government bond yield peak at 3.47%. It subsequently fell during the second half of the month to 3.01%, as growth fears intensified.²

The worry for investors is that the cumulative effect of all these rate increases will be enough to push the economy into a recession. We have also seen a spate of disappointing data releases towards the end of the quarter, further fuelling the recession narrative.

The issue perplexing central banks is the cause of the inflation – is it due to the one-off, large fiscal and monetary stimulus during Covid-19 while supply chains were broken, or has the market fundamentally changed due to de-globalisation and a lack of workers due to demographics and lack of immigration. At the moment the central banks seem confused and panicked, but they are certain that the overall inflation number is too high and that they need to reassert credibility and assert price stability over growth. Both US Core Personal Consumption Expenditures (PCE) and CPI have peaked and have begun declining, but it seems the Fed is looking at the headline number, which is subject to vagaries of the oil price (destroying demand will affect this with a lag). The risk of an accident therefore remains high in our view, and the path to a recession seems quite likely unless headline inflation can make a meaningful move lower.

Trust performance and activity

The company's net asset value (NAV) fell by 12.2% during the quarter, underperforming the benchmark which fell by 9.1%. The share total return was -11.8%.²

To generate the income required, we need to be invested and to be moderately geared. We continued buying back shares in the quarter and will look to continue to do so in the market if we consider it be accretive for the shareholders.

In terms of the credit, market we saw European investment grade spreads widen by 83bps and deliver -7.3%, US investment grade bonds widen 42bps and deliver -6.7%, European high yield widen 241bps and deliver -10.8%, and US high yield widen 244ps and deliver -10.0%. The widening happened predominately in June, which marked the second worst month for US and European high yield bonds since 2008.²

In terms of primary activity during the period, we have seen reduced primary issuance in both the European and US investment grade markets, as well as very little issuance in either Europe or US high yield markets as issuers and arrangers were contending with highly volatile markets. We have seen a pick-up in distressed debt with the total now $26.9 billion, split between $15 billion for bonds and $11.9 billion for loans,over the first six months of the year in the US. The US high yield bond default rate stood at 1.08% and European high yield bonds at 0.5% at the end of the quarter.² The overall level of distress in the market has begun picking up from a low base.

Outlook/strategy

We have been buying more investment grade bonds during the quarter as we get more defensive in light of our rate of change model, which has correctly picked up a rapidly decelerating growth cycle. We have also been reducing positions in B-rated and CCC-rated credit and reduced the company's high yield bond holdings by 4.6% (adding 3.9% to investment grade). We remain fully invested in what we see as "reason to exist" large cap credit around what we see as the BB and BBB-rated sweet spot. Our focus on providing a relatively consistent and attractive income stream to investors means that the company's investments are naturally skewed to lower-rated issuers in fairly defensive sectors.