The £82m Henderson Diversified Income trust, run by John Pattullo and Jenna Barnard (pictured), is currently paying out a yield of 5.7 per cent, according to the AIC, and trading on a 1 per cent premium, down from a one-year average of 1.6 per cent, according to Numis. Last year the trust issued 10 per cent of its share capital into strong demand, and it plans to issue more in 2014.
The fund is unique in that 50 per cent of its cash is invested in floating rate loans issued by corporations, the only closed-ended fund with this profile.
The loans are pegged to LIBOR and the coupon is automatically increased when the former is increased. This means they cut out the risk to bondholders of being left with capital losses and a disappointing yield when interest rates rise.
An open-ended fund can only invest up to 10 per cent in these loans, but the Henderson Diversified Income trust had as much as 80 per cent in the assets shortly after launch.
There are specialist trusts that invest solely in debt, such as Alcentra European Floating Rate Loan, which yields 5 per cent, and NB Floating Rate Income, which yields 4 per cent, but the unique element with this fund is the mixture of floating and fixed rate investments, Cade explains.
“The key differential is that pool of loans, around 50 per cent, and the remainder in high yield, so the mixture of floating rate and fixed rate with the flexibility of the managers to asset-allocate from time, which is how they get the high yield,” Cade said.
“For investors who don’t want to control the duration, then you have an experienced management team to do that for you.”
Alongside the 50 per cent in loans, the fund also has 35 per cent in corporate bonds, 8 per cent in investment grade and 7 per cent in equities.
The managers say that it is in high yield that they are currently finding the best opportunities, and the 50 per cent in loans is close to the lowest it has been since the fund was launched.
The equity exposure, which was introduced at the time of the first Greece crisis in 2012, is also as high as it has ever been. Job Curtis runs this part of the portfolio.
The managers increased their weighting to equities last year, saying there were attractive yields on offer relative to corporate bonds from the same company, in addition to the opportunity for capital growth.
Data from FE Analytics shows that the fund has made a total return in share price terms of 36.88 per cent since launch.
Performance of trust vs sector since July 2007
Source: FE Analytics
The yield of 5.7 per cent puts it among the highest-yielding funds in the IMA Sterling Strategic Bond sector, and much higher than the average UK Equity Income fund.
The portfolio should come into its own during the boom phase of the economic cycle, Barnard explains, when debt is growing faster than profits and interest rates are raised.
Although the portfolio avoids interest rate risk, it makes up for this by being highly sensitive to default rates.
The major risk for holders of loans is that the companies issuing them default. However, the loans that the trust buys have a senior claim to the company’s assets, meaning that they are served first in the case of default.
Historic rates of recovery for these loans after default are 80 per cent, the managers explain, while the remaining 20 per cent is often received in equity which can on occasion even make money.
The comparative recovery rate for European high yield is 40 per cent.
Company default rates are extremely low by historic standards, Pattullo explains, reflecting the existence of “zombie” companies that are being kept alive by cheap financing.
However, the trust could suffer if default rates spike.
Pattullo says that gently rising interest rates would be a boon for the trust, while sharply rising rates would represent more of a problem.
A recurrence of the eurozone crisis or a spike in inflation caused by central bank incompetence could cause a crisis that would also affect the trust, he warns.
However, the manager says that his base case is a long-term creeping rise in interest rates.
Cade notes that the fund woudn’t necessarily be the worst-hit even in such a scenario.
“If you were holding just high yield corporate bonds, you would be hurt more,” he said. “However, given that over 50 per cent is in secured loans, you have to rely on the managers shifting the portfolio around appropriately.”
The board is seeking to raise up to 50 per cent of its share capital over the next 12 months, making it available at a 2 per cent premium to NAV.
The discount has been volatile, our data suggests, ranging from a high of a 6.4 per cent premium to a low of a 3.7 per cent discount.
Share price and NAV over 1yr
Source: FE Analytics
Cade says that the main negative point for anyone looking to invest is the charges.
“The key question is the performance fee on the fund,” he said.
The fund applies a 15 per cent performance fee on any returns above three-month LIBOR plus 125 basis points, and three month LIBOR is currently only at 1.75 per cent, meaning this is not a steep hurdle to climb.
According to Numis, ongoing charges are 2.48 per cent, inclusive of the performance fee.