Advertisement

There’s still money in bonds for careful investors

Investors should tread carefully in the fixed-income market. But this well-managed investment trust fits the bill.

With ten-year UK government bonds yielding well under 1%, the consensus view on the bond market is overwhelmingly bearish: even if inflation stays around 2%, governments’ reluctance to control fiscal deficits implies more bond issuance, lower prices and higher yields.

John Pattullo, the manager of Henderson Diversified Income Trust (LSE: HDIV) is deeply sceptical about this view. He points out that forecasters have called for lower bond yields in only two of the last 26 years, yet ten-year US Treasury yields have headed remorselessly down, from 7% to below 2%. Moreover, the notion that high fiscal deficits mean high bond yields is “fake news. Everyone focuses on the supply of bonds, but in a flight to safety, demand for bonds also rises”.

The experts get it wrong

He accepts that “from here, it is tougher, but the idea that you can’t make money from bonds is wrong”. For example, the ten-year US Treasury was yielding 3.25% in 2018 with bond-market gurus such as Bill Gross and Jamie Dimon forecasting that the Trump tax cuts would push yields higher. Their subsequent near-halving produced a capital return of over 15%. Meanwhile, negative yields might seem crazy but, hedged back into sterling, ten-year Japanese and eurozone government bonds yielded over 1% in December, higher than comparable UK bonds.

Advertisement - Article continues below
Advertisement
Advertisement - Article continues below

Pattullo thinks that a realistic yield for good-quality BBB corporate bonds hedged into sterling is 2.2% and for lower-quality (but not junk) bonds is 3.3%. The default risk is very low, but the illiquidity risk justifies the corresponding spread over government bonds. He describes yields above 5% as “fool’s yield”, quoting Russell Napier: “the most dangerous form of speculation is the reach for yield. Virtually everyone believes they have a moral right to a 5% yield and if they can’t get it in a high-quality security, they will find it in low quality”. Pattullo points to the lengthening list of loan funds, such as Funding Circle, Hadrian’s Wall and H2O, which have got into trouble.

Finding “sensible income”

Pattullo focuses instead on “sensible income: the bonds of growth businesses with good equity”. He avoids emerging markets, energy and sectors in structural decline. “We didn’t invest in Thomas Cook, Pizza Express or Holland & Barrett, despite their high yields, because they were value traps.” As a result, the portfolio “has seen more upgrades of bonds to investment grade than downgrades to junk”. The portfolio is currently 42% invested in investment-grade corporate bonds, 51% in high yield and 7% in loans and other debt. Unlike specialist funds, HDI can move between different types of debt according to the available opportunity.

Advertisement - Article continues below

Returns are enhanced by the use of gearing, currently 20% of net assets, mostly through bank debt. This raises returns enough for the shares to yield 4.6%, though at 95p they trade at a 4% premium to net asset value (NAV) of 92p. The dividend, always covered by earnings, was reduced in 2017 and again in 2019 as falling bond yields decreased income; Pattullo refuses to reach for yield with lower-quality investments. Still, a one-year investment return of 15% and a five year one of 32% are impressive.

Pattullo thinks that the cyclical outlook has become less favourable for bonds and that the second half of 2020 may be challenging, although structural factors are still capping long-term bond yields. Given the proliferation of debt funds and the billions invested in them, it is remarkable that such a flexible, diversified and well-managed fund has net assets of only £170m. For those needing to mitigate exposure to equities, it is hard to find a better vehicle, if not now then later in the year when bond yields should be higher.

Advertisement
Advertisement

Recommended

If you think now is a good time to buy, look at these investment trusts
Investment trusts

If you think now is a good time to buy, look at these investment trusts

With the latest market slides, an awful lot of assets are beginning to look very cheap indeed. If you are thinking of buying, Merryn Somerset Webb has…
10 Mar 2020
How to build a properly diversified investment trust portfolio
Sponsored

How to build a properly diversified investment trust portfolio

Max King explains how to build a well diversified portfolio using one of our favourite tools – investment trusts.
25 Feb 2020
Why investment trusts are the best vehicle for your money
Sponsored

Why investment trusts are the best vehicle for your money

Max King explains the advantages of investment trusts – sometimes called closed-ended funds – over their open-ended counterparts (or Oeics).
11 Feb 2020
Investment trusts: the Cinderella of investment arrives at the ball
Funds

Investment trusts: the Cinderella of investment arrives at the ball

Investors should look beyond the market noise of a single year and examine the bigger picture. Max King explains what we can learn from 25 years of in…
8 Jan 2020

Most Popular

Eagle Lightweight GT: the reincarnation of the E-type Jag
Toys and gadgets

Eagle Lightweight GT: the reincarnation of the E-type Jag

Jaguar’s classic E-type sports car has been reinvented for the modern age. The result – the Eagle Lightweight GT – is a thing of beauty.
7 Aug 2020
Platinum: the precious metal that looks set to play catch-up with silver and gold
Silver and other precious metals

Platinum: the precious metal that looks set to play catch-up with silver and gold

Gold and silver continue to soar, but there's still time to get in. And there's another precious metal that looks set to go on a bull run too, says Jo…
7 Aug 2020
Don’t despair on dividends – these companies could be set to bring them back
Income investing

Don’t despair on dividends – these companies could be set to bring them back

The value of dividends paid out by UK stocks has plummeted this year as companies “rebase” their payment policies. But things could soon start to look…
6 Aug 2020