Henderson Diversified Income (HDIV) released its annual results for the year ended 30 April 2023. NAV total return was down 4% for the year, underperforming its benchmark by 3.7%. Shares fared slightly better, down 1% for the year.
It has been a year of two halves for the company with NAV falling by 10.4% through to November, only to recover by 7.1% over the following six months. The manager attributes this underperformance mainly to an overweight position in sterling financial bonds which were badly impacted by the Truss government’s mini budget. A further contributor was their firmly held view that the global economy was in a more precarious position than markets recognised. This caused them to hold an overweight position in higher rated, longer duration, investment grade bonds which are expected to perform well in a falling interest rate environment.
While such a scenario has yet to fully materialise, the manager continues to expect significant economic downturns, in both the US, the company’s largest regional exposure, but also in the Eurozone and UK. They believe the overweight position discussed above will prosper in these circumstances.
Discussing the macro backdrop and investment outlook further, the manager added:
“As discussed in our last outlook we feel the global economy is in a precarious position. The extraordinary size of the monetary and fiscal stimulus to enable a successful exit from COVID has led to a classic sine wave boom/bust business cycle response akin to fighting a war. With the benefit of hindsight policymakers have needed to put the brakes on too late and too hard to stamp down on the less than “transitory” inflationary surge. Bottlenecks were of course compounded by the surprising tightness of the labour market and the Ukraine War adding significant fuel to the fire. Investing at this time in the cycle is always challenging and is often compared to picking up pennies in front of a steam roller. We have seen a very aggressive and broadly co-ordinated tightening in global monetary conditions – it is unusual to have such a synchronised upswing and then downswing across the globe. The good news is that in America, at least, the medicine is working as core and headline inflation have peaked out and are fading. Many of the global supply bottlenecks have disappeared as witnessed by the extra-ordinary slump, albeit from high levels, in vital commodities such as oil, gas, copper and lumber amongst others. Many corporations have found it very hard to manage stock levels given the changing demand patterns, as consumption shifted from stay-at-home goods to “revenge spending” (expenditure meant to make up for lost time after an event such as the pandemic) on services such as eating out and travel.
“The bulk of our portfolio is invested in American companies – the US policy response has been more coherent and successful than Europe and the UK which seem to have some semi-persistent inflation lags. Labour markets are now more balanced, and we expect the cycle to evolve in this area as the long and variable lags of monetary policy begin to bite. Market commentators often say that the Federal Reserve raises rates until something breaks. Well, the aggressive raising on short-term rates altered depositor and investment behaviour most pertinently in some American regional banks. This caused a digital bank run which is a new phenomenon. Further, the swift demise and wipe out of Credit Suisse junior bonds demonstrates the pressure some weaker financial institutions were under, from depositor confidence, not capital. We always keep a keen eye on the quarterly bank lending surveys – these were already tight and interestingly, the most recent surveys highlight a decline in the demand for credit as well as a decrease in the supply and cost of credit.
“As noted earlier, the UK is an outlier, with headline CPI at 8.7% in April, above consensus forecasts of 8.2% and a (still rising) core CPI of 6.8%. Following the robust core inflation print and wage growth at the end of April, the UK data sparked worries about a wage price spiral which meant terminal rate expectations were lifted. This reflects concerns that interest rates have limited traction and that monetary policy is behind the curve. This argument ignores the inherent lags of monetary policy. This repricing has created attractive front-end yields of 6-7.75% for Sterling investment grade bonds.
“This cycle seems like a classic boom/bust one, with potential for significant depth and duration. It is of course an inflationary cycle, and nominal growth has muddied and delayed many historical economic relationships. However, if you believe in business cycle analysis, we continue to remain relatively cautious from here. We expect a significant downturn. This would, with careful judgment, give us an opportunity to gear the company and make back some of what we consider is only temporary depletion of capital. We will continue to stick to our sensible income credit selection strategy into a period of expected volatility.”
Chairman muses on future of the trust
“Whilst share buybacks have been accretive, the size of the company has consequently reduced, and the company remains relatively small, meaning that costs are shared over a diminishing asset base when compared to other investment trusts. These costs eat into the returns available for distribution. This small size also impacts liquidity in the company’s shares.
At inception in 2007, the objective of the company was to invest in a wide range of fixed income instruments including secured loans. This would allow the fund managers to take advantage of the credit cycle to increase the allocation to loans when interest rates rose, protecting investors against capital losses. It was also envisaged there would be opportunities for capital growth in periods of falling interest rates which would enhance total returns.
Quantitative easing and the persistence of negative real interest rates during the last decade were not envisaged at launch. As a consequence, returns from loans have looked relatively unattractive and the fund managers chose not to invest in loans because they felt a reasonable reward was not available for the risks taken. It is not clear whether this will change in the near future.
Of greater concern is the challenge to income in the future. We are very aware that shareholders are principally interested in the yield offered by the company’s shares. The sustainability of this yield, and the risks necessary to achieve it, are an area of increasing focus for the board, especially as revenue reserves have diminished.
The board are therefore concerned that the structure of the company as originally envisaged does not allow the fund managers to preserve the real value of the capital of its shareholders, and feel that perhaps an alternative investment process could offer greater scope to provide a more consistent return to our shareholders. The board have not reached any conclusions on these matters but will be considering options for the company in the near term. We will report any recommendations to you as soon as we are able.”
HDIV : Defensive positioning continues to weigh on Henderson Diversified Income