Equity-income roundtable: The changing interest rate environment

Michele Robitaille, managing director and equity-income specialist at Guardian LP, a sub-advisor to the BMO family of funds. The Guardian equity team’s mandates include BMO Growth & Income and BMO Monthly High Income II.

Jason Gibbs, vice-president and portfolio manager at GCIC Ltd. Gibbs is a senior member of GCIC’s equity-income team, which has a wide range of mandates including Scotia Canadian Dividend, Scotia Diversified Monthly Income and Scotia Income Advantage.

Peter Frost, vice-president and portfolio manager at AGF Investments Inc. Frost’s responsibilities include two income-oriented balanced funds: AGF Monthly High Income and AGF Traditional Income. He also manages AGF Canadian Stock, the domestic-equity flagship.

Q: The interest-rate environment is changing. Let’s discuss the impact on the equity-income universe?

Robitaille: There has been a change in investor psychology starting with the discussion about Fed tapering in May. It prompted investors to look longer-term and recognize that they are in an era when interest rates are going to be going up. The May tapering discussion had a significant impact on the bond and equity markets. You saw 10-year bond yields in both Canada and the United States move up dramatically over the following two-month period. You also saw most of the yield-oriented sectors of the Canadian equity market selling off, including the real estate investment trusts (REITs), the pipelines and the utilities. The telecom-services stocks have their own dynamics.

Gibbs: At the start of 2013, there were a lot of renters in the equity-income segment. When interest rates bottomed in February/March, a lot of investors piled into, say, REITS, utilities and pipelines, without necessarily understanding their fundamentals. This was the case both in the United States and Canada. Those price charts went parabolic in February, March and April. The May tapering discussion saw some of those renters leave the equity-income space. This was part of the sharp correction in some of these names. The REITs, for example, experienced a fairly steep decline.

Frost: The REIT correction was big.

Robitaille: Most equity-income sectors corrected by a good 10%. The correction was quick too. The REIT correction was probably closer to 15%. The utilities corrected strongly too.

Gibbs: The REITs have rebounded.

Frost: So have utilities, after interest rates pulled back from their peak.

Q: What happened to bank stocks during this summer sell-off?

Gibbs: They did well.

Frost: The valuations were attractive. There was also a lot of short covering by U.S. investors.

Gibbs: In summary, the year started with an emphasis on pipelines, utilities and REITs, which all took off. That switched in May/June when investors piled into higher-growth names, including brand-name technology stocks. This is starting to level off. After all, we are in a deleveraging world. This means sub-par global economic growth and low inflation rates. Interest rates are still going to remain relatively low for the long term.

Frost: The macro picture does not match the exuberance in the equity market. Earnings are all right, but not great.

Q: Time to talk about the relative performance of the Canadian equity-income universe and the REITs versus the composite?

Robitaille: In the first 10 months of 2013, the S&P/TSX Equity Income Index’s total return was 13.85% and the S&P/TSX Capped REIT Index’s total return was negative 5.62%. The S&P/TSX Composite Index’s total return was 10.28%. The equity-income index also outperformed the composite over the 12 months to the end of October, with a total return of 14.81% versus 10.99% for the composite. The REIT index had a negative total return of 3.40% over that period.

Q: Valuation and prospects?

Frost: Valuation of equity-income securities looks much more reasonable compared to the broader market. You should also look at these income-generating stocks against alternative income sources, such as bonds. Investors are looking at these dividend-paying stocks for income replacement.

Gibbs: The equity-income stocks are still reasonably valued. We look at free-cash-flow yields and dividend growth. This year has demonstrated the need for dividend growth from these businesses.

Robitaille: This shift could adversely impact some of the REITs.

Gibbs: It could also impact some of the utilities.

Robitaille: The growth prospects of some of the other equity-income companies, like energy infrastructure companies, are pretty dramatic relative to what they were historically. They are both high-dividend-paying companies and they also have good growth prospects. This growth is important, if we do get into a higher interest-rate environment.

Gibbs: The pipeline stocks, specifically, had a few years of major outperformance. They are levelling off a little this year. It’s still an excellent sector to be in.

Frost: I would much rather be in a company like Enbridge Inc. (TSX:ENB) than a bond.

Q: It is seven years since the Halloween announcement by Finance Minister Jim Flaherty that Ottawa was changing the tax treatment of the then robust Canadian income-trust universe. How has the equity-income space changed?

Frost: Many trusts have adapted well to a corporate structure. The demand for income is unlikely to stop. Investors are struggling to find income from their bond portfolios and are looking to their equity portfolios for this. Many companies have realized this and are more focused on providing income.

Robitaille: There have been a lot of companies that have instituted a dividend for the first time or have increased their dividend. This is also in non-traditional areas such as the oil-services companies and the fertilizer companies. There are a few non-corporate structures left, outside of the REITs, which were grandfathered. Most of the larger, well-established income trusts have migrated quite easily.

We have expanded the number of sectors that we invest in from the time when our funds were focused on the then higher-yielding income trusts. There has been a narrowing of the gap between the yields on former income trusts and, say, the banks. It’s a combination of the yields on the ex-income trusts coming down a little and the yields on some of these other names rising. There has been a meeting in the middle.

Gibbs: The income-trust boom in Canada was a sign of the times and it was early. Investor demand for cash flow and income was starting to increase, as the income-trust boom took off. This demand continued into the income trusts’ growth phase. Since then, this demand for income has speeded up all over the world. A relatively stable company with a lot of free cash is facing pressures from its investor base to give back a lot of that free cash flow in the form of dividends, dividend increases and share buy-backs. Companies are still growing, but this growth is smarter.

Frost: It makes management more disciplined in the allocation of capital when it is required to give some of it back to shareholders.

Robitaille: The reality is that a lot of companies over the years have wasted a lot of shareholder capital trying to find growth.

Gibbs: Seven years later, the income theme continues stronger than ever. They just don’t call them income trusts. Companies are responding to the demand for income. For example, Tim Hortons Inc. (TSX:THI) , though it is facing a lot of competition, generates a lot of free cash flow. A few activists suggested that the company put more leverage on its balance sheet and give more of the free cash flow back to shareholders. Tim Hortons responded and this has helped the stock.

Frost: The same trend is noticeable in the energy patch. Oil and gas producers have always been focused on growth, but now they are more focused on profitable growth and giving more capital back to shareholders.

This three-part series continues on Wednesday and concludes on Friday.

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