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.
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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.
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.
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