(January 2006) As the hurdles to income trust investment have fallen, more and more cash has flowed into the structures, driving a demand for research. Unfortunately, the majority of income trusts represent operations that can only be considered small- or even micro-cap businesses, resulting in limited analyst coverage.
This is slowly changing, with more institutional analysts covering the sector, but one of the earliest forms of independent research is still the most widely relied upon — stability ratings.
In the early days of the income trust phenomenon, there was no research. Eventually the countries’ leading bond ratings agencies seized upon this absence and offered their expertise in evaluating the stability of individual trusts’ pay out.
Stability ratings are issued by both Standard and Poor’s (S&P) and Dominion Bond Rating Service (DBRS). Each firm uses a scale of one to seven, with a rating of “one” indicating most stable. There are variations within each of the seven ratings and the two firms use different labelling conventions — Standard and Poor’s would rate the most stable trusts as SR-1, while DBRS would rate them STA-1.
Speaking at Insight Information’s fourth annual Income Trust Conference in Toronto, Matthew Kolodzie, senior vice president at DBRS, emphasizes that the ratings are not a buy or sell recommendation, but he points out there is a strong correlation between ratings and yield.
Those that receive the STA-1 rating tend to see their unit price bid higher, driving their distribution yield lower. Those with a STA-7 rating tend to offer a higher yield. There are exceptions, of course, such as the Canadian Oil Sands, which has proven so popular among investors that it yields less than 3%, despite a middle rating.
“In order to achieve a high stability rating, it has to have pretty good financial flexibility. That includes cash reserves, credit facilities or very strong sponsorship,” Kolodzie said.
DBRS currently rates 66 trusts on the market, but Kolodzie said the firm’s goal is to cover at least those that are included on the S&P/TSX Composite Index. Standard and Poor’s has ratings for 36 trusts.
“An acceptable payout ratio is highly dependent on the fund itself and the industry characteristics,” he said. “It’s acceptable for a non-cyclical fund to have a very high payout ratio, whereas a fund that’s in a cyclical industry, we’d expect it to have a much lower payout ratio under normal conditions so it can deal with fluctuations in, say, commodity prices.”
But it’s not just small-time DIY investors who are incorrectly relying on stability ratings.
“I personally don’t use stability ratings, but I know that a lot of brokers and retail investors do use them,” says Alice Sun Dunning, executive director, institutional equity research at CIBC World Markets. “I get calls from my brokers internally asking for recommendations on income trusts with specific stability ratings.”
She said the ratings are useful, especially for independent investors who have access to little alternative research, but that they are just one tool in the due diligence process.
Adding to the perception that stability and quality go hand in hand, some closed-end funds even use the stability ratings as a marketing ploy, such as the Citadel S-1 Income Trust, which uses the highest stability rating right in its name.
“I think investors should make an informed decision when using stability ratings and use them appropriately and be aware of some issues that may influence their decision making process,” Sun Dunning says. “Not only are stability ratings used by individual retail investors who have no access to other information, they’re also used by investment advisors in terms of selecting income trust investments for their clients.”
Stability ratings should not be confused with buy, sell or hold recommendations. Nor should the absence of a stability rating be seen as a lack of quality. The cost of maintaining coverage runs into the tens of thousands of dollars, an expense that many trusts may not deem worthwhile.
Also, a solid market following can negate the need for a stability rating. Knowing that some investors prefer strictly S-1 rated trusts, those that will only rate an S-4 see little point in advertising to investors that they do not meet the S-1-only criteria.
“If a trust is not rated, it doesn’t mean there is something wrong with its performance,” Sun Dunning says. “Issuers may not want to pay for a rating that may be lower than what the market perceives.”
She suggests that a risk rating be introduced; separate from the stability rating, which could indicate the risk associated with the trust’s underlying industry, allowing high quality trusts in a higher risk group to receive ratings more reflective of their quality.
“If investors incorrectly limit themselves to income trusts to income trusts with stability ratings of one to three, without properly accounting for their risk appetite, they could miss out on some quality but higher risk investment that may also be appropriate for their portfolio and risk profile,” she says.
Dunning gives an example of ratings diverging from overall investment quality in trusts. Algonquin Power initially received an S&P rating of S-2, thanks to its long term contracts to supply energy to established buyers.
Meanwhile, Canadian Oil Sands Trust was only rated SR-4, due to its exposure to fluctuations in the price of oil. This trust is considered one of the darlings not only of the oilpatch, but of the trust market as a whole. Within the past 52 weeks, the unit price has soared from $64 to more than $143.
“When you compare the basic fundamentals of the two trusts, Algonquin Power has experienced declining cash flow generation due to operational problems,” she said. “As a result, the fund had to reduce the distributions payable and ever since they came onto the market they have been paying out more than 100% in terms of payout ratio.”
Any investor who shunned mid-level rated trusts missed out on the fantastic gains realized by investors who bought into Canadian Oil Sands. Stability ratings may predict the likelihood of distribution cuts, but they do not assess upside risks.