Despite continuing uncertainty in the broader markets caused by the war in Iraq and terrorism, the income trust sector continues to perform well.
Since the beginning of the year, the S&P/TSX Canadian Income Trust Index has provided returns of 2.3 percent as of March 13. This compares to the S&P/TSX Total Return Index, which has lost 5.5 percent for the same period.
From the beginning of 1998 to March 13, the S&P/TSX Canadian Income Trust Index returned 79.8 percent compared to 0.8 percent for the TSX Total Return Index.
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Since last year the income trust universe has grown by more than $45 billion, spread over four asset classes: oil and gas royalty trusts; real estate investment trusts; power and pipeline trusts; and business trusts.
As of Jan. 27, there were 104 publicly traded income trusts. Growth was driven predominantly by initial public offerings of business trusts. This growth can be attributed to a combination of factors:
- A market that is receptive to yields offered by income trusts in today’s low interest rate environment.
- Volatility in the debt and equity markets deferring participation from issuers and investors.
- Strong interest for businesses to convert from corporate structures to trust structures, given attractive asset valuations upon conversion.
- Corporate tax savings for issuers and tax deferral benefits for investors. Recent developments have created increased acceptance and demand for income trusts.
- Standard & Poor’s, which designs and manages the Canadian equity indices, established three new TSX trust indices last October. The S&P/TSX Canadian Income Trust Index is a broad-based composite index that may include all sectors of the income trust marketplace. Income trusts that qualify for inclusion must derive their distribution income from actual business operations.
The relative weights of individual constituent income trusts are capped at 25 percent. There are now 41constituents.
The S&P/TSX Canadian Energy Trust Index and the S&P/TSX Canadian REIT Index are subsets of the broad-based Income Trust Index.
- The issue of unitholder liability appears headed for resolution. In the past, institutional investors, such as pension funds, were put off by the possibility of an income trust investor being liable in excess of his investment in the trust units. Any move to eliminate the unlimited
liability would almost certainly lead to trusts being added to pension fund portfolios.
The Ontario Teachers Pension Plan Board recently made an unprecedented move by participating in an income trust offering before this resolution.
This would also undoubtedly lead to their admittance into the S&P/TSX composite index. Institutional index funds would be required to buy the trusts, thus injecting billions of dollars in new investment capital into the sector.
As well, rating agencies have increased their coverage of the sector.
Standard & Poor’s was the first agency to devise ratings. It assigns a stability rating, ranging from SR-1 to SR-7, reflecting its assessment of the underlying trust business model, its sustainability, and the variability in distributable cash flow generation in the medium to long term.
The SR-1 rating represents the most stable trusts, while SR-7 is seen as the least stable.
Within the respective asset classes, power and pipeline trusts are recognized for their predictable cash flows and are awarded ratings of SR-1 and SR-2. REITs represent a wide range of underlying business operations and exhibit moderate to high stability of cash flows.
While the majority of REIT stability ratings will be SR-3 and SR-4, some can achieve ratings as high as SR-2 and low as SR-5. The business trust asset class is diverse and so ratings have a wider range, depending on the underlying business and financial profile. Business trusts are rated between SR-4 and SR-6.
Oil and gas royalty trusts are characterized by uncertain stability of cash flows, given the volatility of commodity prices and declining reserves, and are generally assigned stability ratings of SR-5 and SR-6.
The Dominion Bond Rating Agency recently announced its intention to cover the sector with stability opinions. This will help investment advisers do their research.
As institutions such as the pension funds enter the income trust sector, it’s likely that rating agency considerations will drive investment decisions.
I favour the business trust asset class because it is the most economically sensitive and capable of growing its distributions in an improving economy. Because the Bank of Canada has been increasing interest rates, this is a good indicator of an improving economy in Canada.
Underlying businesses within this asset class vary from waste management to private label manufacturers.
Some examples of business trusts that I like include the BFI Canada Income Fund, which is one of the largest full-service waste management companies in Canada, and Associated Brands Income Fund, a leading supplier of private-label dry blend food for grocers in North America. Both provide forecasted pre-tax yields of more than nine percent and some tax deferral in 2003, while providing for capital appreciation since their initial public offerings within the past year.
Ian Morrison is an investment adviser with Wood Gundy Private Client Investments in Calgary and is licensed to sell insurance products. His views do not necessarily reflect those of CIBC World Markets Inc. or The Western Producer. Morrison can be reached at 800-332-1407 or by e-mail at ian.morrison@cibc.ca.
