Income trusts have taken a beating recently, but the decline may have been overdone.
Since March 25, when the Government of Canada 10-year bond yield hit a low of 4.18 percent, the S&P/TSX Capped Income Trust Total Return Index has fallen 6.9 percent. That compares to the TSX Composite Total Return Index, which fell 4.5 percent as of May 10.
The decline in the income trust sector can be attributed to a rising 10-year bond yield, which peaked on May 10 at 4.8 percent on speculation that interest rates would increase on the back of strong U.S. economic indicators such as sales and employment numbers.
Read Also
Agriculture needs to prepare for government spending cuts
As government makes necessary cuts to spending, what can be reduced or restructured in the budgets for agriculture?
However, our internal economists forecast that interest rates will likely not increase until mid-2005 and they believe the 10-year bond yield will decrease to 4.4 percent by September, four percent by December, 3.95 percent by June 2005 and increase to 4.15 by December 2005.
They believe that expectations for repeated, early U.S. interest rate hikes are overdone. In living memory, no Federal Reserve Board has ever begun monetary tightening during a presidential election year.
I believe the Fed won’t break from this longstanding tradition, given low core inflation of only two percent or less and doubts about the economy’s fortunes as the reaction from U.S. tax cuts fades.
Rising interest rates are even less likely in Canada.
First quarter growth in Canada slumped below two percent on an annualized basis and job creation is low. Instead of a rate hike, our economists are calling for another rate cut to 1.75 percent in Canada.
With this argument for modest inflation and stable interest rates, I believe the sell off in the trust asset class is overdone.
The yields of most trusts improved considerably as they sold off and in most instances are at a far better yield spread to their average historic spread to 10 year bonds. If most of these trusts return to their historical yield spreads, it would result in respectable price increases.
Even more compelling are the positive underlying fundamentals within the asset class that have been caused by moderate economic growth, improving profitability and a firm Canadian dollar.
In recent weeks we have seen a flurry of positive financial reports and increased distributions from trusts. Of the 67 business trusts that have had their initial public offerings since the beginning of 2001, 23 have increased their distributions while only six lowered them. Real Estate Investment Trusts are typically “late cycle” sector performers and Energy Trusts are supported by strong supply-demand fundamentals accentuated by global political uncertainties.
The demand dynamics for the trust asset class couldn’t be better because of good demand from aging baby boomers and retiring Canadians. Institutional and international demand is in its infancy and we are seeing a strong asset allocation shift from bonds as well as stocks.
I view the recent weakness within the trust asset class as a normal consolidation. It offers an opportunity to income-oriented investors to improve the quality of their portfolios by adding selectively to positions whenever trust prices slump.
Income trusts are Canada’s highest yielding and most tax effective equity income vehicles. Fixed income vehicles are uncompetitive on an after-tax and after-inflation basis. For conservative, income-oriented investors, income trusts offer one of the best risk-return ratios in the Canadian markets.
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.
