Good times may not last, S&P warns

While Canada looks like it’s in for another strong year, Standard & Poor’s is warning that the conditions that led to the rapid growth in 2005 are starting to fray. In other words, 2006 may be fine but 2007 is another story.

On the one hand, unanticipated inflation increases due to higher commodity prices and the flight of the loonie threaten to throw off economic growth. And more Canadians are spending all of their income and taking on debt.

S&P director Robert Palombi sees Canada heading towards a soft landing. The cost competitiveness of the manufacturing sector could be undermined and interest rates look as though they will continue to increase — with the Bank of Canada seen raising rates to 4% by mid-year.

However, income funds could come under pressure this year despite the abundance of cash many funds current have on their balance sheets. The powerful component on the Canadian market, a point made clear back in October when the federal government suspended advanced tax rulings on the structure, will face mounting pressure to grow distributable cash flow.

The growth initiatives will apply pressure on both management strategy and financial policy. Oil-based funds will feel this pressure the most as they start using some of their excess cash to acquire new assets — and that won’t come cheap as asset prices remain high.

Debt will be used to ‘tweak’ returns, says Ronald Charbon, a director for S&P’s stability ratings group. Investors looking in this investment class should move back to basics and perform more fundamental analysis. As a result, there will be a greater scrutiny on reporting standards and disclosure practices as well as on the quality of the cash flow and how the income trust calculates its distributable cash.

To help, Charbon directs investors to S&P’s distribution profile assessment (DPA), which considers an income funds distribution policy in the context of its cash flow dynamics and examines the funds ability to maintain a given level of distributions. That’s somewhat different from S&P’s stability ratings, which incorporates the DPA. The stability rating gauges the stability of cash flow generation within a specific income fund.

The reason, Charbon explains, is that DPA is more likely to change before the stability rating. Since the end of September there have seven income funds had their DPA’s changes, but there has been only one stability rating change.

Filed by Mark Brown, Advisor.ca, mark.brown@advisor.rogers.com

(02/17/06)