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TAL managers predict rising interest rates will have only a minor impact on income trusts

by Wayne Cheveldayoff, 2005-07-07

Will rising interest rates scuttle the booming income trust market? Not according to a recent research paper on income trusts published by two portfolio managers specializing in trusts at TAL Global Asset Management.

The main conclusion of their noteworthy report, which sketches out a number of possible scenarios, is that income trust yields are likely to rise (and unit prices fall) in line with interest rate increases in the months ahead, but all in a “mild” way.

Furthermore, if the Bank of Canada begins to raise interest rates, there is no reason to panic. The best protection for investors is to ensure they carefully pick the trusts they own because some will fare a lot better than others in a rising interest rate environment.

The research paper, by David Graham and Gaelen Morphet, who manage Talvest and Renaissance mutual funds, made a number of important observations related to the interest rate sensitivity of trusts.

First, mid and long-term bond yield changes have the most impact on income trusts. This means movements in short-term rates, including the overnight rate controlled by the Bank of Canada, are not really relevant. Instead, investors should focus on what the Government of Canada 10-year bond yield is doing.

This is an important distinction because while the U.S. Federal Reserve has been raising short-term interest rates for the past year, the U.S. 10-year treasury yield has actually fallen. If the same happens in Canada, Bank of Canada action to raise short-term rates could actually be supportive of trusts.

Second, income trusts, which are really high-yield equities, are likely to respond in a muted fashion much like utility stocks in relation to changes in the 10-year bond yield. During periods of rising rates in the past decade, utility stocks fell on average by only 5.6 per cent, with a total return, including dividends, of minus 3 per cent.

Third, since many investors do not understand the complexities of the drivers behind income trust performance, the initial market reaction to interest rate changes will be speculative and emotional, causing unit values to drop too far and creating a buying opportunity.

Fourth, the key to successful income trust investing is to understand the fundamentals of each underlying business or industry. Picking trusts with strong fundamentals will help investors weather an interest rate storm and, over time, outperform the broad income trust market.

The research paper notes that income trusts have been so popular in recent years that the trust average yield spread against the 10-year Canada bond yield has narrowed significantly – from as high as 8 per cent in 2003 to the 4.5 to 5 per cent range currently.

Looking ahead, the TAL managers don’t expect any further narrowing. The spread, though it is historically narrow, is likely to stay constant as rates rise, with trust yields rising as much as rates.

In a scenario where the spread remains constant in this way at approximately 4.7 per cent and 10-year bond yields rise somewhat, by 0.4 percentage points, in line with the consensus forecast of Bay Street economists, investors can expect average unit values to fall by 3.6 per cent – implying a total return for trusts of about 5.5 per cent from May 2005 to December 2006.

In a more pessimistic scenario, with bond yields rising the same amount but the trust-bond yield spread widening out to the longer-term average of 5.6 per cent, unit values would fall by 11.6 per cent – implying a total return of minus 2.4 per cent over the 19-month period.

However, if the spread instead narrowed to 3.7 per cent, which is the lowest it has reached in the recent bull run for trusts, average unit values would actually rise by 8 per cent – implying a total return of 17.2 per cent.

The authors note that while understanding interest rate sensitivity is extremely important, it doesn’t dominate their investment decisions.

They say that as bottom-up stock pickers, they believe the correct way to value income trusts is to analyze the underlying businesses, just as they would do with any common stock, paying special attention to cash flow and sustainability metrics, which vary according to the industry.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at and he can be contacted at

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©2005 Wayne Cheveldayoff