Trust rally could still have legs

By Steven Lamb | November 30, 2005 | Last updated on November 30, 2005
4 min read

The past few years have seen an extraordinary explosion among income trusts, as valuations have surged and new issues have come to market either through an initial public offering or through the conversion of existing corporate structures. With market-leading returns, some question whether the rally can be sustained. GGOF’s John Priestman, lead manager of the firm’s Monthly High Income Fund says there is still a lot to be optimistic about.

“Don’t expect the kind of returns that we’ve had for the last three years, where we’ve been clocking along at about a 20% total rate of return,” he said on Tuesday at GGOF’s Investment Summit 2005 in Toronto. “But I have a positive outlook for next year and I think eight to 10 [per cent] is certainly in the cards.

He says the entry of “some big new players” into the marketplace should support trusts for at least another year.

“I think the new players coming into the marketplace this year will be pension funds and I think they’ll be big players over the next couple of years,” he said. “I also think we’ll have a big pick up of interest in foreign ownership.”

So far, institutional investors have managed to find new excuses to avoid the trusts: first it was limited liability, then index inclusion and most recently, the review of the sector by the federal government, which Ottawa abruptly ended last week.

“We were certainly surprised by the outcome last week. We didn’t think individual investors in Canada would be harmed, obviously, as this is the asset class of choice for aging baby-boomers and retired Canadians,” he said. “We were surprised that foreign ownership wasn’t restricted to 49% or 50% — putting a hard limit on foreign ownership seemed like an appropriate thing to do. Foreigners are essentially only paying a 15% withholding tax on the income they receive.”

With the elimination of the foreign property rule earlier this year, some have predicted that pensions may continue to avoid trusts by investing more overseas, but Priestman thinks there is room for both assets in pension portfolios.

“What we think they will do is look for growth opportunities outside of Canada, and income opportunities inside of Canada, he said.”I think they will be looking at dividend growth plays as well as income trusts.

“It’s the only asset class that provides an upfront return that’s equal to their actuarial liabilities — most pension funds need an eight or nine per cent return to fund their future pension liabilities and right now the income trust index composite is yielding about 8.5%.”

He says Canadian equities make up about 25% of the total holdings of Canadian pension funds, or about $170 billion. When income trusts are eventually fully integrated into the composite index, they will make up about 10% of the total index. With a penchant for tracking indices, pension funds are poised to buy up to $17 billion in income trusts over the next 24 months.

There is a short-term downside for trusts, as the annual redemption window is now open for many of the closed end funds. Priestman says it is likely that up to $500 million worth of trust holdings could be sold off in December before that window closes.

“We also feel the closed end players are going to take their show on the road,” Priestman said, pointing to a limited pool of viable trust conversions in Canada. “They are going to go to the U.K. and the U.S. and do more of their deals outside of Canada.”

The latest in the long list of complaints among trusts has been the high-profile reduction of some trusts’ distribution.

“I know there have been a lot of negative articles in the media about distribution cuts. They’ve principally been in secondary and tertiary business trusts,” he said. “I think the real story this year — and why performance has been so good — has been the distribution increases that we’ve had in the oilpatch.”

By his calculations, so long as oil remains above $45 a barrel, the top half of the oil royalty trusts can easily meet all of their payments obligations, including their distributions. Oil futures are currently pointing to a price somewhere in the mid $50 range for the foreseeable future.

“There are 37 energy trusts and I think with one exception virtually all of the energy trusts have increased their distributions at least two times — and I wouldn’t be surprised if we have some year-end ‘specials’.

“That’s allowed a lot of the open-ended fund managers to pay bonus distributions,” he said. “I think before all is said and done this year, we’ll probably pay about two years of income in a 12-month period.”

As for portfolio strategy, Priestman calls REITs the “heart and soul” of his fund, as they occupy the middle ground on the interest rate sensitivity continuum. With rates expected to rise, he says he is loading up on rate insensitive trusts from the energy sector and higher quality business trusts. Trusts in regulated industries like power and utilities tend to underperform in a rising rate environment and are therefore currently less favoured.

Priestman says he and his team prefer conversions of existing businesses from a corporate structure to a trust as an entry point, rather than IPOs of previously unlisted firms with no track record.

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Steven Lamb