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Henderson Diversified Income hit by ‘fundamental change in perception of inflation’

Henderson Diversified Income hit by ‘fundamental change in perception of inflation’ – Henderson Diversified Income (HDIV) has posted its annual results for the year to 30 April 2022, during which time its NAV total return was down by 9%, reflecting a fundamental change in the perception of inflation risk by the market. The share price total return was also down, by 10.4% reflecting a small widening in the discount. The dividend was covered by revenues and was maintained at 4.40p. 

For the year ended 30 April 2022, a third interim dividend of 1.10p per ordinary share was paid on 31 March 2022 and a fourth interim dividend of 1.10p per ordinary share was paid on 30 June 2022 making a total of 4.40p per ordinary share for the year, in line with expectations. These dividends have been paid as interest distributions for UK tax purposes.

Extract from the manager’s report:

Macro background

In the last 6 monthly report we said that we felt equities were euphoric, credit spreads were reassuringly expensive and volatility was supressed.  We expected a tougher regime going forwards and we have certainly got one!  When running a geared Company investing in fixed interest whose primary objective is the consistent generation of a reasonable income stream without permanent capital destruction, throughout the economic cycle, the start of a rising interest rate period and end of a recovery is always going to be challenging.  The skill is to avoid defaults and invest in quality resilient businesses which are sustainable in the true meaning of the word.  Shareholders will be aware of our sensible income approach which focuses on large, modern day digital businesses at the lower end of investment grade, BBB and the top end of high yield, BB whilst avoiding the heavy cyclicals, analogues, small caps and structural losers.  The NAV has fallen but we feel is more temporarily impaired rather than permanently lost. In this period we have underperformed the benchmark.  In hindsight we had too little loans which in a relative sense performed very well, and too little lower quality high yield whilst having too much better quality, but more interest rate sensitive BBB investment grade bonds.  The issue with loans is because they float over short-term interest rates they did not yield enough to justify a material part of the Company’s portfolio.  In addition, secured loans have financed more of the marginal and arguably lower quality issuance this cycle, compared to high yield bonds.  The average quality (and credit rating) of loans has deteriorated over recent years, whereas the opposite is true for high yield bonds.  We expect this deviation in quality of issuance to become apparent in time.  This is the first year of using the indicative benchmark and we suggest it should be used over the long-term for sensible appraisal.  In addition, and somewhat ironically, the better quality bonds, generally being longer duration performed worse than the lower quality single B and CCC bonds.  In this rather bizarre period the heavily cyclicals and of course energy were the relative outperformers!  So what has happened? 

Sovereign bonds have sold off very aggressively due to the Federal Reserve, amongst other Central Banks having a ‘volte-face’ regarding inflation not being transitory.  The panic that inflation may become entrenched has led to an extraordinarily aggressive and late change in monetary policy reaction function.  Bond markets on both sides of the Atlantic are currently pricing in an extraordinary number of rate hikes.  This panic was compounded by the exceptionally tight labour markets experienced post pandemic and many workers (particularly those of 50+ years) have chosen not to re-participate in the labour markets (the great resignation).  The Ukraine war has of course heightened and extended the inflation scare via the exceptionally high oil price.  The Fed was already behind the curve and saw a shrinking window of opportunity to raise rates very quickly into an already slowing economy – they were still buying Treasury and mortgage bonds in March!  It is important to highlight that during this period most of the capital loss was experienced in 2022 and was due not to credit spreads widening but due to the aggressive sell off in the underlying sovereign bond (which is an important part of a corporate bond).  It is only really in the period post year end that the credit spreads have widened aggressively and the worse credits have underperformed, but this is a story for next year’s review.

Policy makers and companies are struggling to assess the new normal of activity post pandemic so this environment was always going to be volatile with massive swings in all economic data.   Recent profits warnings from some of America’s biggest retailers emphasise how many companies have over-earned, over stocked and over hired on an unsustainable basis. We are now faced with super high energy costs, a strong dollar, a very flat yield curve and slowing growth in money supply – all the ingredients necessary for a recession.  We feel a hard landing is almost certain in the UK and Europe, with a less severe downturn expected in America.  The bulk of the assets remain in American/global businesses.  We are all grappling with the consequences of the war-like response of monetary and fiscal stimulus to boast the economies.  Unfortunately, we are now in the tough medicine period – we expect the economic cycles to be shorter and more sine wave than prior periods – the COVID echo could last for some time.

Asset Allocation & Activity 

We were conscious of how late cycle it felt this time last year.  High yield tends to trade with vintages and the recent crop was not necessarily that bad but worth avoiding on a valuation basis alone, along with other criteria.  Thus we have bought limited high yield and been especially focused on avoiding some rather large Sterling issuance namely, Morrisons, Asda and more recently Miller homes.  This year we have trimmed high yield in favour of adding to select loan names and investment grade bonds.  This is really a defensive trade, upping the quality whilst not jeopardising the income stream.  Thus we reduced some of the higher beta names in high yield.  Some notable sales include all of the high yield companies exposed to the food industry, including: Pilgrim Pride (US meat processor), Lamb Weston (US producer of frozen potato products), Post Holdings (US manufacturer of cereal products) which we think are all exposed to rising raw material costs that they will struggle to pass through to customers hence impacting profitability.  In terms of activity we added names in the primary market including Clarivate Science (global software, data and analytics), Transunion (US credit reporting agency) and Ultimate Kronos Group (Human Resources SaaS provider) which fits in with our theme of modern economy companies with decent organic growth, recurring sales, and conservative balance sheets that define the sector. 

The portfolio remains primarily focused around BBB and BB credit in fairly defensive sectors. To generate the income we need to be invested and to be moderately geared.  We feel reasonably confident in maintaining the dividend from here accepting we are going into a much tougher environment.  Gearing has been set around a level sufficient to marginally cover the dividend but no more.  We have and will continue to buy back loose shares in the market if considered accretive for the shareholders.

HDIV : Henderson Diversified Income hit by ‘fundamental change in perception of inflation’

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