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Disclosure – Independent Investment Research

This is independent research issued by Kepler Partners LLP. The analyst who has prepared this research is not aware of Kepler Partners LLP having a relationship with the company covered in this research report and/or a conflict of interest which is likely to impair the objectivity of the research and this report should accordingly be viewed as independent.

Overview
HDIV offers a compromise between high yield and security…
Overview

Henderson Diversified Income (HDIV) invests across the fixed income markets in search of a high and sustainable yield. It is effectively an income-focused strategic bond fund of the sort more commonly found in an open-ended structure, but with the flexibility to take on gearing, hold more illiquid assets and to remain more fully invested without keeping cash on hand to manage redemptions. These advantages mean HDIV yields 4.7%, while the same managers’ three open-ended strategic bond funds yield 4%, 3.7% and 2.4%.

Co-managers Jenna Barnard and John Pattullo take a cautious approach to credit selection, aiming to generate steady income through the cycle. Issuer selection focuses on identifying non-cyclical businesses with sustainable cashflows which they think should make dividends secure. The managers focus on conventional fixed income – high yield and investment grade – and currently limit exposure to less liquid areas which offer higher yields but greater risk in market corrections.

Their bearish outlook on economic growth and inflation means the trust has done well in periods when government bonds have rallied, such as 2019. Despite their cautious outlook the portfolio’s duration, or interest rate risk, has been higher than many peers, against the consensus view (see Performance section). John and Jenna have thus benefited from their continued ‘lower for longer’ view.

Over 2019, the trust swung from a discount to a premium rating of 5.1% as demand for the shares rallied in a period of falling interest rates. The discount volatility remains high, however, thanks to the high valuations in the bond market, the jittery nature of risk appetite and no use of share issuance to limit the premium (as we discuss in the Discount section).

Analyst's View

HDIV is an interesting compromise between yield and security, in our view. The managers’ views on interest rates remaining ‘lower for longer’ have been proven correct (so far, at least) and shareholders have benefited from a more stable NAV in falling equity markets. However, the managers’ commitment to their focus on high quality businesses with sustainable cashflows means that the yield on offer is lower than that available from the other conventional fixed income trusts in the AIC Debt – Loans & Bonds sector.

In our view the trust is likely to do best if rates and growth remain range-bound at low levels, and equity markets make steady gains. Although the high yield credit portfolio is relatively high-quality and highly rated, it would likely experience losses in a severe equity market correction, which could offset gains from the longer duration. Meanwhile, in a strong reflationary equity market rally the high duration could lead to losses. While the credit exposure could do well in such a scenario, HDIV would likely lag its lower quality peers.

For investors who want an income from bonds but are concerned about the possibility of the end of the cycle, HDIV could still fit the bill, however, as it will be more protected than its lower duration and lower credit quality peers. On the other hand, the premium could evaporate in a serious sell-off, as happened in Q4 of 2018. Moreover, the rating has proven extremely volatile in the past, and we would expect this to continue.

There is a great deal of uncertainty around the future course of the global economy, rates and markets. This means that the capital that shifted into fixed income markets in 2019 could quickly be pulled out in 2020. Similarly, the appetite for a more defensive trust like this could easily reduce quite quickly if markets tear away this year. Additionally, the board has not issued shares to control the premium as it does not want to grow the size of the trust in what is a relatively illiquid underlying market. This, and its reluctance to buy back shares in the past when the trust has traded on a small discount, adds to the potential volatility, and so we think investors need to be careful about the rating on which they buy the trust.

BULL BEAR
A high yield on offer relative to equities and government bonds Discount volatility likely to be high
A cautious approach to credit selection which should protect on the downside
Gearing is high which could lead to losses in falling markets
A relatively high duration approach which should diversify the risks in equities
Portfolio would underperform in a sharp reflationary period (rising interest rates)
Continue to Portfolio

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