Like almost every other asset class, income trusts were punished in 2008, as fears of declining earnings and the credit crunch rippled through the economy. And although the market has already priced in a lot of bad news, managers of Canadian income trust equity funds remain cautious about a recovery and defensive in their positioning.

“The bad news that we’re aware of is probably priced into the market,” says Leslie Lundquist, lead manager of Bissett Income Class and senior vice president with Calgary-based Bissett Investment Management Ltd. “What we don’t know is if there is more bad news to come. The difficulties we’ve seen in the U.S. financial system are not limited to the U.S.; they’re having a global impact. We’ve already seen the beginnings of the negative consequences of that.”

And Lundquist won’t predict when the turnaround will happen. “The dominoes have not stopped falling yet,” she says. “The question is: when will they stop?”

Indeed, because the downturn could very well get worse before it gets better, it’s prudent to be cautious, she suggests: “We’re taking the approach that capital could become even more constrained than it already is. There could be even more bad results out of financial institutions and other businesses in the U.S. and Canada. We could continue to have negative growth at home and in other countries.”

Based on that outlook, Lundquist is sticking with tried-and-true firms. “We only want to invest in companies that are conservatively structured, financed, managed and can get through a sustained period of difficulty,” she says. She would rather give up a little of the upside in order not to participate fully in the downside. “We’re buying the things that can survive, even in a difficult time. They will not go up the absolute most once markets recover — but they will participate.”

From a strategic viewpoint, Lundquist has about 40% of the Bissett fund’s assets under management in business trusts, 25% in energy trusts, 15% in real estate investment trusts, 17% in utilities and pipelines, and 3% in cash. One top holding in the 36-name fund is Inter Pipeline Fund, which owns oilsands pipelines, crude-oil pipelines, and liquid natural gas storage facilities and processing plants.

“What we like about these oilsands pipelines is that the owners have a guaranteed income,” says Les Stelmach, an income trust analyst with Bissett. “[Each is] based on what it cost to build, and an allowed rate of return on that pipeline.”

Although volumes have declined, Inter Pipeline is protected by long-term agreements.

A long-term position in the Bissett fund, Inter Pipeline peaked this past summer at $11 a unit, and recently traded around $7.50 a unit.

“There were concerns about financing,” says Stelmach. “But Inter Pipeline has largely alleviated those concerns and concerns about [cash] distributions.” He notes that Inter Pipeline’s distribution yield is 11%.

“Most of the value will come from the distribution,” says Lundquist. “We do not expect a distribution cut come 2011 and beyond. That’s very appealing to us.”

Lundquist has no stated price target for Inter Pipeline.

Another favourite holding is Morneau Sobeco Income Fund, the largest pension and benefits consulting and outsourcing firm in Canada. “It tends to benefit when times are bad for companies,” says Lundquist. “As pension and benefits legislation gets stricter, or companies need to review their pension programs or as they downsize, Morneau Sobeco is a consultant in all of these activities.

“Morneau Sobeco offers a nice history of increases in revenue and cash flow,” she adds. “If we start to see layoffs and more companies reviewing their pension plans, the firm is very well positioned to consult on all of those.”

The Bissett fund acquired its holding in Morneau Sobeco in 2004. The units peaked at $15 a unit in 2008, recently trading at $7.96. The units have an 11.9% yield.



Rather than trying to determine whether the market has bottomed, Hovig Moushian, assistant portfolio manager with Toronto-based Howson Tattersall Investment Counsel Ltd. and co-manager of Saxon High Income Investor Series, argues that valuations of income trusts are among the most attractive seen in many years.

“Valuations are at extremely low levels,” he says, “which is, perhaps, an overreaction by the market.”

But, Moushian notes, the sector is under selling pressure because distribution yields are declining: “In the recent past, there has been a reduction in distributions. Although the indicated yield may be high, the resulting yield over the next year is likely to be lower as distributions are reduced as a result of falling earnings.”

@page_break@Another negative factor is that some income trusts have already converted back to being corporations, in anticipation of the tax rules changing in 2011.

“Some have gone from [being] trusts with very high payout rates to [being] corporations with lower payout rates,” says Richard Howson, co-manager of the Saxon fund and portfolio manager with Howson Tattersall. “They have effectively cut their distributions.”

Yet the fund’s managers believe the income trust sector is attractive because the yield spread — the average distribution yield relative to the yield on 10-year Government of Canada bonds — has almost doubled in the past year to about 13%. Although the yield spread is likely to fall as distributions decline, Moushian notes, the income trust sector remains well priced.

“Looking out, the yield spread will be less than 13%,” he says, “but not as low as the 7% that we saw a year ago.”

Currently, the Saxon fund’s AUM is spread among income trusts (84% of AUM), stocks (15%) and cash (1%). The equities portion previously had been 10% of AUM, but the managers increased it late last year after using the proceeds from sales of several income trusts to acquire Bank of Nova Scotia, Bank of Montreal and Marsulex Inc.

“In the medium to long term, [the banks] will be very attractive investments,” says Howson, noting that the yields in the fund range from 6% to 8%. “Some income trusts will convert to corporations and cut their distributions. We want to be a little ahead of this trend.”

On the income trust side, about 40% of the Saxon fund’s AUM is in business trusts, 23% in energy trusts, 12% in pipelines and utilities, and 9% in REITs. One new holding is Pizza Pizza Royalty Income Fund. “It’s an established business,” says Moushian, “with very attractive valuations.”

Howson notes that because Pizza Pizza is a royalty income trust, investors receive royalties based on revenue, not profits. In addition, Pizza Pizza moved into the Western Canada market last year, when it acquired Pizza 73.

Based on 2% growth in same-store sales and discounted flow analysis, Moushian believes the fair value of Pizza Pizza is $8 a unit; it recently traded at $6.35 a unit and yields 14.6%.

Otherwise, the Saxon fund’s managers continue to favour names such as Medical Facilities Corp., a Canadian income trust that operates specialized surgical hospitals and ambulatory service centres in the U.S. “It’s a stable business,” says Howson, “and a growing one.”

Medical Facilities recently traded at 5.5 times enterprise value to earnings before interest, taxes, depreciation and amortization, and at 0.6 times debt to EBITDA.

“Our estimate of fair value is $12 a unit,” says Moushian. Bought two years ago at around $10 a unit, Medical Facilities recently traded at $8.22 a unit; it yields 13.7%.



It’s still time to be cautious, agrees Sandy McIntyre, manager of Sentry Select Canadian Income Fund and senior vice president with Toronto-based Sentry Select Capital Corp.: “The market is very nervous. I follow the U.S. market for direction. New York drives Toronto, and income trusts follow the broad market.”

McIntyre notes that in the first half of January, the S&P 500 composite index rallied to about 867 points but later declined to 835.

“For me to commit cash, we have to see the S&P 500 rally through the 50-day moving average,” says McIntyre, noting that about 13% of the Sentry Select fund’s AUM is in cash.

And apart from two short-lived rallies, the 50-day moving average has remained in a bear market phase. “This is only the second attempt at a rally in a hideous bear market,” McIntyre says. “It’s premature for me to take scarce cash and commit it.”

Because of weak trading volumes, McIntyre believes that there is not a lot of support for another rally.

“It’s still a dance between buyers and sellers,” he says. “Sellers are trying to let the market lift. But the push behind the market is still pretty anemic.”

McIntyre began to implement a defensive strategy in mid-2006, when the yield curve inverted. He began to eliminate companies with weaker balance sheets.

Another indicator of soft markets is found in currency markets, in which the U.S. dollar remains weak relative to the Japanese yen. “Europeans are still net sellers of U.S. securities,” McIntyre says. “Until we can identify that [that trend] is behind us, I’ll play a very defensive hand.”

From a strategic viewpoint, the Sentry Select fund has about 31% of its AUM in business trusts, 14% in energy trusts, 13% in REITs, 11% in utilities and infrastructure, as well as the 13% in cash. There is also about 18% in common stocks, composed of telecommunications stocks and one bank, National Bank of Canada.

One of the largest holdings in the 50-name fund is Parkland Income Fund, a wholesale and retail distributor of gasoline, diesel, propane and heating oil in Western Canada. “It has exposure to refining margins and handles distribution for Imperial Oil Ltd. and runs Esso gas stations in Alberta,” says McIntyre. “It is a cyclical business, but it is very efficiently run.”

Although Parkland — which has little debt — saw its units sold off considerably on concerns of weak gas margins, McIntyre has been buying it because fuel is an essential commodity. A long-term holding, Parkland was recently trading at $7.20 a unit, less than half its $15 peak in 2008. It has a 17.6% distribution yield.

Another favourite is Bell Aliant Regional Communications Income Fund. It has seen modest declines in the so-called “landline” segment as consumers move to cellphone services, says McIntyre. But Bell Aliant has made gains by offering cable services on its network.

“It’s the most advanced of the telecom companies,” says McIntyre, “in competing head to head with the cable companies

Bell Aliant was recently priced at $24.35 a unit, down from last year’s high of $30.50 a unit. Its distribution yield is 11.9%.

McIntyre has not added to the holding, however. “[The holding has] done what it’s supposed to do,” he says, “[which is] act as a defensive position in a weak market.” IE