Advisor Forum update: Income trusts no flash in the pan, advisors told

(October 22, 2004) The booming income trust market will always have its naysayers, but there are compelling reasons to believe that trusts are here to stay and will remain profitable, according to Dean Orrico, portfolio manager at Middlefield Income Funds, who spoke at the Halifax Advisor Forum earlier this week.

Admittedly, Orrico has a vested interest in the sector — his firm manages seven closed-end trusts worth $3.2 billion. But he makes a strong argument that income trusts have evolved beyond a fledgling asset class and will continue to thrive, even if interest rates continue their slow rise.

“Is this a flash in the pan?,” he asked. “Over eight years, income trusts have outperformed every other asset class. Trusts are a great total return vehicle.”

The Canadian trust market has ballooned in the past few years, to 160 issues worth $108 billion. That represents 8% of the TSX’s market cap, Orrico notes.

Of course, that kind of growth inevitably leads to talk of a trust bubble, similar to what happened to tech stocks a few years back. Orrico says it’s not a fair comparison, though.

“The tech market was a bubble because you had companies that had no cash flow and no earnings,” he says. “Trusts are the exact opposite — they generate high levels of cash flow and earnings. So that’s not a bubble, these are real businesses and a lot of them have been around for a long time.”

And since the trust market has now become much larger and therefore more diversified, portfolios can be positioned to offset any rise in interest rates, the fund manager believes.

Orrico manages interest rate risk by currently overweighting in economically sensitive sectors, such as oil and gas and business trusts. “In a period of growth, there’s greater demand for commodities, so oil and gas trusts will enjoy greater revenues and cash flow and pay higher distributions, offsetting rising interest rates. Business trusts also do well during periods of economic growth.”

“If in five years, we thought we were going back into a recessionary environment, we’d skew back to more interest-rate-sensitive trusts, such as power and pipeline. My thesis is that you can create diversification in an income trust portfolio.”

In addition, trusts are reasonably valued, Orrico believes, with a long-term average of 10-11% per annum. “But you’re getting most of that return in the form of current distribution, on a monthly basis and on a tax-efficient basis.”

Oil and gas trusts will continue to outperform, Orrico thinks, even though they are generating cash flow from declining assets. But commodity prices will remain strong for simple supply and demand reasons, he adds.

“World oil production is declining and demand, specifically from the developing world, such as China and India, is growing.”

There’s also good news for income trusts on the political front, with the limited liability issue close to being resolved, says Orrico. “It’s a non-issue in Quebec, it’s been resolved in Alberta where all the oil and gas trusts are, and Ontario just went through the second reading of new legislation proposing limited liability for trusts.” Together, those three provinces represent 95% of Canada’s income trust market.

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Although limited liability is a non-issue for firms like Middlefield, it has kept most of the major pension funds away. Orrico believes that’s about to change. “We think this will be resolved by the end of the year, which will cause another wave of buying by pension funds in Canada,” he says.

“Given their clients’ need for income and their underfunded situations, trusts are a logical alternative for pension funds. If I’m a pension fund investor, I can’t avoid trusts.”

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Dean Orrico is also speaking at the Advisor Forum in Calgary next month. For more information on when Advisor Forum comes to a city near you, please click here.

Filed by Doug Watt, Advisor.ca, doug.watt@advisor.rogers.com

(10/22/04)

Doug Watt