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.  

 

• ¹ Source: BBC news, 10/12/2021 – US inflation hits its highest level in 40 years
• ² Source: The Guardian, 1/12/2021  – Inflation in eurozone soars to 4.9% – highest since euro was introduced
• ³ Source: Morningstar as at 03/01/2022
• ⁴ Source: Bloomberg as at 01/01/20221. All indices are Bloomberg Barclays benchmark government indices. All indices are total return in local currency.
• ⁵ Source: U.S. Junk Bonds Set $432 Billion Record in Rush to Beat Rates: U.S. Junk Bonds Sales Set Annual Record With $432 Billion in 2021 – Bloomberg

Quality of investments