Rethinking the role of bonds

With bond yields close to all-time lows and credit spreads quite tight, what role can bonds play within an equity/bond portfolio going forward? In this article, we discuss the approach adopted by David Smith, Portfolio Manager of Henderson High Income Trust, his underlying rationale, and the impressive results the Trust has delivered.

Understandably impacted by the coronavirus, investors sought safety throughout much of 2020 in fixed income, with bond yields falling to historic lows. As we entered 2021, bond yields rose, and prices fell as investors’ confidence increased on optimism that the global rollout of highly effective vaccines would lead to a relaxation of government restrictions and a sharp recovery in economies. More recently, inflationary pressures have also not helped, with inflation data in the UK, US and Europe rising above central bank targets, further pushing bond yields higher. The debate over whether current high inflation will prove transitory - due to supply bottlenecks caused by the pandemic - won’t be resolved for some time, which means the current outlook for bonds is particularly uncertain. With the asset class providing stable returns historically, one can begin to question the role it plays for equity/bond portfolios going forward.

Henderson High Income Trust, part of the Janus Henderson investment trust range, is one such trust that invests in both equities and fixed income securities to deliver a combination of high income and the potential for capital growth. The bond portfolio has always been a unique feature of the Trust; it dampens the overall volatility of the NAV and offers a predictable revenue stream. While portfolio manager, David Smith, has reduced the allocation to bonds over the last 18 months, recognising the strong performance they have delivered, the uncertain outlook given inflationary pressures, and the limited potential for further capital appreciation - he still believes there is a place for bonds in the Trust.

Bonds provide a diversified source of income for the Trust, something that proved incredibly valuable in 2020, given the significant dividend suspensions and cuts witnessed in the UK equity market. The bond portfolio maintained its level of revenue generated for the Trust and there were no defaults. In addition, bonds also help dampen the overall volatility of the Trust, as they are relatively more resilient than equities at times of economic stress. Once again this proved valuable last year, with the fixed income portfolio returning 7.7% against the FTSE All-Share decline of 9.8% on a total return basis.¹ Finally, the bond portfolio, funded by the Trust’s borrowings, helps to boost the headline dividend yield of Henderson High Income. This aids the portfolio construction of the equity portfolio, meaning David does not have to chase the highest yielding areas of the market where dividends have historically proven to be unsustainable. With this structure, the equity portfolio can focus more on higher-quality companies that offer the potential for long-term capital growth and sustainable dividends that can grow.

Two holdings that bring this strategy sharply into focus are Coca-Cola Hellenic Bottling Company and luxury brand Burberry. Coca-Cola HBC is one of the largest bottlers in the Coca-Cola system, producing, selling, and distributing a wide range of non-alcoholic beverages across developed and emerging markets. The company’s diversified brand portfolio and new products are well positioned to take market share in its growing categories which should underpin robust profit growth going forward. British Heritage brand Burberry has undergone a strategic transformation over the past four years which is starting to gather momentum and should lead to higher growth and margins. Despite both companies having below market dividend yields of 2.3%, they offer potential for capital growth and superior dividend growth.

Owning these types of companies has helped the Trust to recover strongly. The share price and net asset value have grown by 41% and over 29%, respectively, on a total return basis over the last 12 months²– both well ahead of the benchmark. The Trust has also outperformed over 3, 5 and 10-years. Furthermore, the Trust has delivered on income, with the dividend payout raised again in 2020, as it has been in every consecutive year since 2012, evidencing the robustness of the Trust's revenue reserves.[1] The dividend yield currently stands at an attractive 5.6%², with the Board committed to at least maintaining the current level of payment in 2021.³

2020 was a very challenging environment for income seekers, and 2021 has brought about a different set of challenges for investors. The Trust’s ability to invest a small portion of its portfolio in bonds helps dampen overall volatility, especially during equity market drawdowns, diversifies the income stream and aids the equity portfolio positioning towards companies that offer the potential for capital growth. Henderson High Income has a unique structure but one that it plays to its advantages.

¹ Source: Henderson High Income Trust PLC, Annual Report 2020
² Source: Henderson High Income Trust factsheet, 31.08.21
³ Source: Henderson High Income Trust PLC, Half Year Report 2021

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