Suits investors, particularly those in retirement, who need a regular income. It might also be appropriate for more cautious investors looking for an alternative to cash deposits.

Henderson Diversified Income Limited uniquely combines expertise in investment grade bonds, high yield bonds and specialist secured loans. It aims for consistently high income, capital preservation over all periods and the prospect of capital growth over the long term. The managers have the flexibility to invest across the whole of this asset class, the freedom to invest in secured loans without limit, and directly in equities when appropriate.

• Henderson Diversified Income offers investors diversification of their income portfolios both through exposure away from equity income and also by offering a wide range of lower risk, fixed interest and floating rate instruments.
• The Fund Manager actively asset allocates between fixed and floating rate instruments to take advantage of changing market conditions.
• The ability to invest in Secured Loans when desired means that an increase in the bank interest rate would result in an increase in distributable income and dividends.

• Higher yielding bonds are issued by companies that may have greater difficulty in repaying their financial obligations. High yield bonds are not traded as frequently as government bonds and therefore may be more difficult to trade in distressed markets.
• Investors need to be aware of exchange rates. Not all the investments in this portfolio are made in Sterling, so exchange rates could affect the value of and income from your investment. Full details of risks.

The Company’s net asset value rose modestly over the month. Credit markets rallied after a poor November. Junior banking bonds and high yield credit outperformed investment grade bonds, gilts and secured loans respectively, though all were positive. The eighth euro crisis summit of the year disappointed, lacking firm action and tangible commitments. However, there were two notable policy actions during the month: firstly, the co-ordinated dollar swap line programme instigated by six central banks meant European banks could get access to cheap dollar funding and secondly, the European Central Bank offered unlimited three-year LTRO (longer term re-financing operations) funding at 1% to European banks in late December. It also lowered the quality of collateral it would accept into these lending operations. €489bn was borrowed by 523 banks - the net new funding amount was just shy of €200bn; this is ‘quantitative easing by the back door’. However, the jury is still out as to whether the peripheral banks can be encouraged to buy their own sovereign bonds whilst the continent slips into recession.

During the month a number of bond buy backs were announced from continental banks and, most notably, Barclays, which helped sentiment in this sector. Daily Mail also made a bond tender offer. Given the outlook we continued to reduce our exposure to financial credit and the odd marginal high yield bond. We hold no continental banks as the balance of financials is held in UK insurers. Telecommunications, media and technology is our dominant sector in the high yield space. Towards the end of December we added some generic risk positions using credit derivative indices. These indices are very liquid and are being used tactically when appropriate.

No new positions were added to the loan portfolio during the month. Leveraged loans were up, with a return of +0.5% for the month. The three-year discount margin, which is the additional return expected over the loan yield at par, was 830 basis points (8.3%), with an average market price of 83.2 where the redemption value is 100. Given all the macroeconomic headlines, the underlying loan portfolio has seen some softening in financial performance during the second half of 2011 but, on the whole, corporate balance sheets are robust. The primary pipeline of new deals in Europe is looking thin at present, driven by buyers concerned about the European sovereign situation. Opportunities in 2012 are likely to come from the secondary market, which has re-priced during 2011, and a few new primary issues. We believe that defaults will modestly increase in 2012, mainly consisting of companies that defaulted in 2008-09 and have still not properly fixed their capital structure.

Going forward, we favour the middle ground of credit in the BBB and BB areas, with selective non-cyclical single B-rated credits. Gilt yields hit record lows - under 2% - during the month so we see no value here. We are also avoiding cyclical CCC and single B credits, which in our view will struggle in a recession. We believe sensible carry trades are the mantra as investors are effectively getting paid for taking on risk. We expect flare ups in volatility but look to exploit these using our flexible gearing and derivative strategy when appropriate. Finally, we paid our fourth interim dividend of the year at the enhanced rate of 1.25p.
 
John Pattullo/Jenna Barnard
December 2011