This was the year the humble income trust grew up.
The most important development in income trusts wasn't Ottawa's two-month flirtation with a new trust tax (abandoned just before the election call). It wasn't the decision by Standard & Poor's to put them in the S&P/TSX composite index. It was that people got some perspective, and began to see trusts as not so different from other companies -- with good ones, lousy ones and everything in between.
So 2005 became the year of divergence, when trust investors learned (often the hard way) that a very high yield can be a warning sign. With trusts, as with stocks, it's dividend growth and quality that really matter.
The blue-chip trusts grew to a size where they could no longer be ignored by even the most hardened trust haters. Yellow Pages Income Fund made two sizable acquisitions and, at $7.7-billion, has a market capitalization larger than every Canadian media firm and all the cable companies but one. Canadian Oil Sands Trust, with a value of $11.6-billion, is larger than about half the companies in the S&P/TSX 60, the most exclusive Canadian index. It may some day join that club.
As for the bad ones -- and there proved to be many more of them than people expected -- they slipped ever closer to irrelevance. There were spectacular blowups.
Two new trusts, Arriscraft International Income Fund and mortgage company FMF Capital Group Ltd. suspended distributions and lost most of their value within months of going public. Investors in FMF launched a class-action suit against the underwriters. We saw the first bankruptcy court filing of a business trust, Heating Oil Partners Income Fund.
At least 16 income trusts cut distributions, and a 17th, Chemtrade Logistics Income Fund, warned it will likely have to do so in 2006.
"It was a crazy year," said Chris Rankin, a business trust analyst at Canaccord Capital Corp. But as far as distribution cuts go, "they're not even done yet," he says. Another trust analyst, speaking on condition of anonymity, says: "The investor backlash is going to be really bad. Unfortunately, we don't have many good ones coming to the market."
The distribution cuts put a damper on investors' returns, and business trusts didn't do as well as you might have expected in 2005, given the prevailing low interest rates. The S&P/TSX capped income trust index was up 21 per cent, but most of the gains were fuelled by energy trusts, which jumped 37.7 per cent.
The biggest enemy for business trusts in 2006 may indeed reside in Ottawa, but his name is not Ralph Goodale. It's David Dodge, Governor of the Bank of Canada, who might drive the Canadian dollar even higher with more interest rate hikes next year. If there was one common thread running through most of the busted trusts, it was currency.
The loonie's rise against the U.S. dollar this year was modest -- 3.3 per cent. But when added to large currency gains in 2003 and 2004, it was enough to cripple some trusts that make a large portion of their sales in U.S. dollars. Menu Foods Income Fund (dog food), SFK Pulp Fund, ACS Media Income Fund (the Yellow Pages of Alaska) and Associated Brands (food and household products) all fall into that category. All went public when the Canadian dollar was much lower.
One other thing unified the broken trusts. They went public promising to pay out almost every dime in cash flow, giving them little room to absorb currency shocks or higher costs, such as natural gas.
That might change. "I'd forecast for 2006 that investors are going to mature, and when they see a new trust that comes out and the payout ratio is 100 per cent, they'll say, 'That's a danger sign and I'm not going to buy it,' " says Rick Howson, chief investment officer at Howson Tattersall Investment Counsel. "I think they're going to look for a greater margin of safety."
Joining the S&P/TSX composite, as 72 trusts did in mid-December, will also have an impact, and not merely because large pension and index funds will own more trusts. Governance, a weak spot in the trust world, will have to improve. So will financial disclosure. "Those trusts that are in the index are going to have to start reporting like the big boys," says Dirk Lever, a trust analyst at RBC Dominion Securities Inc.
And don't be surprised to see more merger activity, Mr. Lever says. M&A fever has been going strong among oil and gas trusts, and now it's starting to infect business trusts as well (witness Livingston International Income Fund, a customs broker, and its pursuit of PBB Global Logistics Income Fund).
The reason is simple. Most business trusts are small, with less than $500-million in market cap. Until now, they've been able to garner an inordinate amount of investors' attention because there were relatively few of them.
But their scarcity value is disappearing as the number of trusts multiplies (there are now more than 200), and the index inclusion of the large ones will further marginalize the small ones.
It's a new world for trusts -- one in which investors are getting smarter, more sophisticated and more careful about where they put their bucks. For companies ill-suited to be trusts -- and that's a long list -- it's terrible news. For the rest, it's an encouraging development.
© The Globe and Mail
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