For financial professionals in the UK

Why Style and Quality Matter

Jenna Barnard, CFA

Jenna Barnard, CFA

Co-Head of Global Bonds | Portfolio Manager


John Pattullo

John Pattullo

Co-Head of Global Bonds | Portfolio Manager


14 Jan 2022
5 minute read

In a market environment characterised by uncertainty and record low yields, some investors have leaned towards riskier segments of the market. However, at what cost? This article looks at how investors have navigated the testing market in the hunt for yield and how the Henderson Diversified Income Trust has stuck to its tried and tested investment approach to produce a consistent, stable, and sensible income for its shareholders.

While 2021 was a breath of fresh air for equities, it was a challenging year for fixed income investors in general. Bonds underperformed equities as yields rose from near record levels, whilst equity markets were buoyed by optimism over a global economic recovery and strong performance – particularly from growth stocks. That being said, bonds still continue to play a crucial role in portfolios as they provide diversification and dampen volatility for those investors with exposure to equity markets.

Divided recovery

2021 provided a positive backdrop for risk assets – the rollout of coronavirus vaccines allowed economies to reopen, while fiscal and monetary stimulus boosted demand. However, as economies opened, supply struggled to cope with the supercharged recovery following the steep COVID-19 induced recession of 2020. As a result, bottlenecks emerged across supply chains, with shortages of inputs and labour weighing on the pace of recovery. Oil prices shot up and consumer prices have followed suit, with inflation reaching its highest level in decades across key markets. US inflation hit 6.8% YoY in November – a 40 year high1 – while eurozone inflation soared to 4.9%, the highest reading since records began in 1997, two years before the euro was launched.2

Against the spectre of rising price levels, central banks have begun to rein in quantitative easing, and some are beginning to raise interest rates – posing a further challenge to fixed income investors: how to strike the right balance between capital preservation and income.

Yield hungry investors

Amidst such a backdrop, defensive fixed-income assets have lagged compared to riskier segments of the market3. For instance, despite rising towards the back end of the year, US government bonds ended 2021 down 2.3% – their worst year since 2013, while UK and eurozone government bonds returned -5.3% and -3.5%, respectively. Meanwhile, US high yield bonds returned 5.4%, while eurozone high yield bonds climbed 3.4% over the same period.4

Rather than sensibly searching for yield, some investors have been reaching for yield – scrambling to find higher yields, and often not paying due regard to the risks involved. In 2021, there were increased flows into higher yielding assets, including emerging market debt, high yield corporate bonds, private and alternative credit. Corporate debt issuers were also keen to take advantage of historically low borrowing costs before the US Federal Reserve began hiking interest rates. By early November, US high yield bond issuance had surpassed the record issuance of 2020, which itself exceeded the previous record set in 20125. Although much of this was driven by the refinancing of existing debt.

Source: Bloomberg as at 09/11/2021 

Style and quality matter

The Henderson Diversified Income Trust, managed by John Pattullo and Jenna Barnard, seeks to provide shareholders with a high level of income while preserving capital growth over the long term by investing in a diversified portfolio of global fixed income and floating-rate assets. The team can invest in high yield corporate bonds, investment grade corporate bonds, government bonds and secured loans, with no limits on the underlying percentages held in each. Although high yield bonds currently account for nearly 60% of its holdings, John, and Jenna focus on selecting high-quality bonds within the segment. Investment grade corporate bonds represent the next highest allocation within the portfolio, at 30%.  

The Trust has a long-term track record of delivering a consistent and “sensible income” underpinned by the teams clear and disciplined investment approach. John and Jenna liken their investment approach to that of a growth manager with the equity space. As such, they invest in companies with sustainable yields, with a bias towards the sweet spot of BB and BBB-rated bonds. Historically, bonds of this quality have tended to produce the best risk-adjusted returns. So it is no surprise that the portfolio consists of large, high quality, less cyclical modern-day businesses with sustainable revenues. Some examples include exciting and innovative companies such as cloud computing firm Rackspace Technology, cybersecurity company Crowdstrike and financial services and digital business Square.  

Their approach contrasts that of most bond managers, who are more akin to value managers. Value managers focus on the yield on offer, but often yields are higher whilst underlying valuations are depressed for fundamental reasons. For instance, managers with a value bias tend to favour companies with old business models heavily dependent on traditional economic activity; small British analog businesses such as food manufacturer Premier Foods and restaurant operator Pizza Express come to mind. In tough times, companies such as these – struggling against structural headwinds – may not mean revert, with their underlying revenues failing to recover to historical averages. Instead, such businesses may simply go bust, as has occurred with Pizza Express in the past.  

The Trust is similarly less likely to invest in the old economy, such as big oil majors, whose fortunes are tied to volatile energy prices. Instead, the team focuses on structural winners, preferring companies like Netflix over physical cinema operators and digital businesses/data centres over physical shopping centres. Even before the pandemic, shopping centres were facing many challenges: the rise of ecommerce, shrinking foot traffic and changing consumer preferences have threatened the traditional way of shopping for decades. Covid-19 accelerated these trends and created a more digital centric consumer who expects frictionless transactions, personalized experienced, and elevated conveniences.  

The teams’ sensible income philosophy also means that they prefer to invest in stable businesses with a yield of 4%, for example, compared with the 6% yields typically targeted by those interested in the more risky, cyclical issuers. The higher yields from this group are much less likely to be sustainable over the long term and naturally carry a greater risk of capital loss. However, by investing in stable businesses, there is less volatility within the portfolio, resulting in a smoother ride in the rough times and sustainable income over the longer term.  

Stay the course 

With the market outlook remaining uncertain and challenging; a stable, and consistent income is more important than ever for many investors. Interest rates look set to rise as central banks attempt to quell inflation, while Covid-19 variants will continue to create bouts of volatility, particularly in equity markets. Therefore, those looking to achieve sensible, long-term returns from their fixed income allocation should ensure that it is well diversified and consists of good quality companies with stable yields – all be it with a reasonable amount of debt on their balance sheets. In an uncertain world – quality matters. And the Henderson Diversified Income Trust will stick to its tried and test investment approach: investing in larger, less cyclical modern facing businesses which have sustainable revenues to produce a sensible and consistent income for its shareholders.  

 

Glossary Terms Expand

Cyclical stock – A cyclical stock is a stock that’s price is affected by macroeconomic or systematic changes in the overall economy. Cyclical stocks are known for following the cycles of an economy through expansion, peak, recession, and recovery. Most cyclical stocks involve companies that sell consumer discretionary items that consumers buy more during a booming economy but spend less on during a recession. 

Fiscal policy – Government policy relating to setting tax rates and spending levels. It is separate from monetary policy, which is typically set by a central bank. Fiscal austerity refers to raising taxes and/or cutting spending in an attempt to reduce government debt. Fiscal expansion (or ‘stimulus’) refers to an increase in government spending and/or a reduction in taxes.  

Growth stock – Shares of a company which generally show above-average earnings and that are expected to grow at a rate significantly above the average growth for the market.  

Inflation – The rate at which the prices of goods and services are rising in an economy. The CPI and RPI are two common measures.  

Monetary policy – The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money. 

Quantitative easing – An unconventional monetary policy used by central banks to stimulate the economy by boosting the amount of overall money in the banking system. 

Value stock – Shares of a company that appear to trade at a lower price relative to the company’s fundamentals, such as dividends, earnings, or sales. 

Volatility – The rate and extent at which the price of a portfolio, security, or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. It is used as a measure of the riskiness of an investment 

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.

 

Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

 

The information in this article does not qualify as an investment recommendation.

 

Marketing Communication.

 

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Important information

Please read the following important information regarding funds related to this article.

Before investing in an investment trust referred to in this document, you should satisfy yourself as to its suitability and the risks involved, you may wish to consult a financial adviser. This is a marketing communication. Please refer to the AIFMD Disclosure document and Annual Report of the AIF before making any final investment decisions.
    Specific risks
  • If a Company's portfolio is concentrated towards a particular country or geographical region, the investment carries greater risk than a portfolio that is diversified across more countries.
  • Higher yielding bonds are issued by companies that may have greater difficulty in repaying their financial obligations. High yield bonds are not traded as frequently as government bonds and therefore may be more difficult to trade in distressed markets.
  • This Company is suitable to be used as one component of several within a diversified investment portfolio. Investors should consider carefully the proportion of their portfolio invested in this Company.
  • Active management techniques that have worked well in normal market conditions could prove ineffective or negative for performance at other times.
  • The Company could lose money if a counterparty with which it trades becomes unwilling or unable to meet its obligations to the Company.
  • The return on your investment is directly related to the prevailing market price of the Company's shares, which will trade at a varying discount (or premium) relative to the value of the underlying assets of the Company. As a result, losses (or gains) may be higher or lower than those of the Company's assets.
  • The Company may use gearing (borrowing to invest) as part of its investment strategy. If the Company utilises its ability to gear, the profits and losses incurred by the Company can be greater than those of a Company that does not use gearing.
  • All or part of the Company's management fee is taken from its capital. While this allows more income to be paid, it may also restrict capital growth or even result in capital erosion over time.