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Benefits and Pensions MonitorUnderstanding Income Trusts: Coming To An Index Near YouBy: Alan Wicks, Duncan Anderson, Jonathan Popper & Conrad Dabiet Income trusts have been on a tear the last few years. New regulatory and market changes could make them an even more integral part of Canadian capital markets in years to come. Income trusts have outperformed the S&P/TSX Composite Total Return index every year since 2000. Assets grew at a compound annual rate of 49 per cent in the four years through December 2004 and comprised 179 funds with a market cap of $123 billion, or nine per cent of the Canadian equity market, in January 2005. The Canadian income trust landscape includes oil and gas royalty trusts, real estate investment trusts (REITs), utility trusts, and a diverse array of specialty business trusts that now account for more than 50 per cent of all income funds. Eliminates Double Taxation
The ideal income trust candidate is a mature business that generates high, stable cash flows. A payout that leaves a cushion for the impact of changing interest rates or business conditions on cash available for distribution is preferable. Trusts have been attractive to issuers because of the ‘pop’ in equity valuations that typically follow news that a company is converting to a trust. In an era of low bond yields, income-starved investors have gobbled up high-yielding trusts. Diversification Benefits The current environment of moderate economic growth and still low interest rates is a bit of a sweet spot for income trusts. If rates keep rising, yield spreads will narrow and the cash available for distributions will fall. If rates fall, it means the economy is slowing and that distributions are at risk. The best-case scenario is for rates to remain little changed, with returns and valuations driven by distributions. Ontario, Alberta, and Quebec have introduced limited liability legislation for income trusts that may boost the comfort level for some investors in owning trusts. The Toronto Stock Exchange will include about 60 trusts (based on size and liquidity) in the S&P/TSX Composite Index from July 1. The trusts will have an eight to 10 per cent weighting on the index, felt most heavily in the energy and financial sectors. These moves will support the next big leg up in the market, the trust conversion of much bigger companies that need a large institutional investor base and have the liquidity to support it. Canada is a mature economy with lots of stable companies that lack strong growth opportunities to drive shareholder value. Think telcos. Think utilities. Think of how governments will respond to that tax revenue loss. Provincial tax revenue will be diverted to the province where unit holders are domiciled. Tax on trust distributions to nontaxable pension plans could be deferred indefinitely. With institutional interest already large and growing, however, it will be difficult for governments to put the income trust genie back in the bottle. |
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Like bonds, income trusts are very sensitive to interest rates. As government bond yields rise, income trust yield spreads narrow and valuations fall. Unlike bonds, income trust distributions aren’t fixed and there’s no par value. Rising interest rates hurt the profitability of underlying operations, cutting the cash available for distribution. Economically sensitive trusts can sometimes offset capital losses due to rising interest rates by boosting distributions as the economy strengthens, but only if the fundamentals and cash flows of the operating company improve with the economy.