Henderson High underperformance driven by gearing

Henderson High Income (HHI) has announced its annual results for the half year ended 30 June 2020, during which, despite being defensively positioned, it underperformed its benchmark primarily due to its gearing which is a key component of its structure that allows it to generate its high level of income. The announcement says that, during the first half of 2020, HHI delivered a NAV total return (with debt at fair value) of -18.1%, compared to its benchmark total return of -13.3% and compared to the FTSE All-Share total return of -17.5% for the same period.

Gearing reduced during the period

During this period, HHI made the decision to reduce its borrowings by approximately £13 million, principally by selling US investment grade bonds which had performed well in capital terms since their purchase. About three quarters of the Company’s loans are now being used to fund the Company’s fixed interest holdings, which effectively yield 5.0% compared to the Company’s current average cost of borrowing of 2.4%. The overall level of gearing as at 30 June 2020 was 20.9%, but only about 6.0% relates to the financing of additional equities in the portfolio.

The board will use revenue reserves to maintain the dividend at 2.475p

The first interim dividend of 2.475p per share was paid on 24 April 2020 and the second interim dividend for the same amount was paid on 31 July 2020. At the time that the second interim dividend was announced, HHI’s Board said its intention was use its revenue reserves where necessary to maintain the quarterly dividend of 2.475p per share for the remainder of this financial year. The board has now reaffirmed this commitment.

Manager’s comments on markets

It has been an extraordinary period for markets in the first half of the year.  During the first quarter global equities experienced a sharp sell-off, with the FTSE All-Share falling 34% in only 22 trading days between February and March, as COVID-19 spread around the world and governments enforced “lockdowns” on their citizens.  As the crisis escalated, investors sold out of risk assets, fearing the worst in terms of the impact on the global economy and corporate profitability. Saudi Arabia and Russia also entered into an unexpected oil price war, resulting in the oil price plummeting and even entering negative territory for a short period.

Equity markets then staged an impressive recovery from their March lows, driven by unprecedented levels of monetary and fiscal stimulus and other government support schemes.  They were further buoyed by the pace of new virus infections slowing and governments starting to relax lockdown restrictions.  Despite the strong rebound in the second quarter, the FTSE All-Share was still down 17.5% over the half year. Defensive sectors outperformed, with the likes of pharmaceuticals and food retailers producing positive returns, while cyclical sectors and those most impacted from government lockdowns underperformed, such as housebuilders, banks and travel & leisure.  Given the fears over global economic growth, bonds performed well over the period as investors sought their safe haven status.  Government bond yields fell to record new lows in the period with the 10 year UK Gilt yield ending June at just 0.17%.

Manager’s comments on Performance

The Company’s NAV (with debt at fair value) was weak during the period, falling 18.1%, underperforming the benchmark’s return of -13.3%, but performing broadly in line with the UK equity market.  Despite the equity and bond portfolios outperforming their respective benchmarks, this was offset by the Company’s gearing and overweight position in equities relative to the benchmark.  Against the extreme market backdrop, the Company’s holdings in more defensive sectors such as utilities, pharmaceuticals and consumer staples were positive for relative performance. Companies such as National Grid, Roche, Sanofi and Unilever are well placed for more difficult economic times and held up well as a result. Positions in Cranswick and Hilton Food Group also helped performance. Given these companies are involved in the production and packaging of food products respectively, the increased demand from consumers in the current environment helped support profits even with higher costs needed to safeguard employees and customers.

The most significant detractors from performance came from those companies that are most impacted from government “lockdowns”, such as National Express, events company Informa and Premier Inn owner Whitbread. These companies’ short term cash flows have been significantly affected by the restrictions on the movement of people and the reduced economic activity that has resulted. Along with many other companies in the UK market they have all suspended dividend payments and raised capital to protect their cash flow and financial strength in the short term.  This is clearly the correct course of action for these companies in order to support their businesses at an unprecedented time. We supported each equity raise as we believe they are good quality businesses that will emerge from the current crisis in a strong position relative to their competition.

Manager’s comments on Portfolio Activity

Early in the crisis we were quick to reduce the cyclicality of the equity portfolio, selling IAG (the holding company of British Airways) and Ibstock in January and Jupiter Fund Management, aerospace company Senior and housebuilder Vistry in March.  The proceeds were used to increase holdings in more stable businesses that should have dependable cash flows and dividends, such as British American Tobacco, Unilever, Reckitt Benckiser and the French pharmaceutical company Sanofi. We also reduced the gearing of the Company in early March to more appropriate levels given the very uncertain outlook, selling £13m of holdings in US investment grade corporate bonds. These bonds had performed particularly well since purchase, with yields moving to extremely low levels which did not offer compelling value, especially against the Company’s cost of borrowing.  Gearing and the bond allocation finished the period at 20.9% and 13.3% respectively.

Dividend suspensions, deferrals and cuts have been extremely prevalent in the first half of the year as companies prioritise their financial security over shareholders’ returns.  Although the Company aims to own good quality businesses that can pay sustainable dividends, it has not been immune in the current environment. The focus has been to utilise the Company’s structure to best support the revenue account and dividends but also maintaining potential for capital recovery. As mentioned above we have taken a pragmatic view to dividend cuts, supporting those companies we believe have the best long term potential despite no dividends in the short term and sold those businesses that have cancelled dividends and where we have less faith over the medium term recovery prospects, such as HSBC, BT and Hammerson.  We have materially increased the holdings in overseas companies, buying high quality businesses with good long term growth prospects that continue to pay attractive dividends, such as McDonald’s and Coca-Cola in the US and European utilities EDP and RWE, which are both underpinned by growth in renewable power generation.

[QD comment: given the extreme nature of the market dislocation caused by covid-19, this is perhaps no great surprise. While HHI maintains a high level of gearing, this is primarily used to fund fixed income positions that provide the income that HHI needs to maintain its high yield and so the gearing on its equity portfolio is much lower. As would be expected, the portfolio was positioned defensively but in market extremes such as we have seen, all assets tend to become highly correlated, so the defensive equities and fixed income holdings would have been pulled down as well. However, assuming that the fixed income positions are able to avoid defaults and markets eventually normalise, there should be good reversionary potential within the portoflio.]