Why Style and Quality Matter

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.