Like it or not, rates will rise

(March 21, 2005) On Tuesday, the Federal Reserve is widely expected to raise interest rates south of the border, making it the seventh consecutive credit-tightening move. So far, the Bank of Canada has been reluctant to follow suit, partly as a measure to bring the soaring Canadian dollar back under control.

But eventually, the low interest rate environment will have to come to an end in Canada — along with all of the benefits that environment has engendered. Aside from the boom in the housing market, one of the most high profile benefits to Canadians has been the flourishing income trust market, as investors search for something — anything — to satisfy their appetite for yield.

“In the past when we’ve seen U.S. rate increases, the Canadian trust market hasn’t usually reacted all that much,” says Leslie Lundquist, manager of Bissett Income Trust & Dividend Fund. “For the Canadian trusts, the greater concern will be what happens when Canadian rates start to rise.

“I think some of the rate fears are already priced into the market — that might be some of the volatility we’ve seen over the past few weeks, recognition that the best days of rate decreases are behind us and that at some point we will get rate increases. Investors are aware that income trusts will be sensitive to interest rates.”

Like many in the market, Lundquist has been expecting the Bank of Canada to hike interest rates for the past couple of years.

“If it becomes apparent that Canadian rates are going to go up, and it’s not going to be a one- or two-time event, then I think all income trusts will feel that to some degree. Some of them will be more hard-hit than others.”

This is because there is a continuum of sensitivity within the trust market, with pipeline and power utility trusts tending to be more rate sensitive, while business trusts can often be more economically sensitive. Since central bankers use interest rates to cool off the economy, rate hikes are often seen as an indication of strong growth.

“The perception of rate sensitivity is greater than the reality of rate sensitivity,” she says. “I was surprised by how weak the REITs got when there were interest rate fears back in March and April last year. Ultimately, the market does what it’s going to do. We argue that it doesn’t make sense, but the market doesn’t care what I think. If they think they’re rate sensitive, they’ll sell them off whether I like it or not.”

Of course, astute managers can always add to their position in trusts they feel are oversold — whether the market likes it or not. Lundquist says there is typically a lag between rates rising and any benefits being seen in the economically-sensitive trusts.

Lundquist acknowledges that even the less rate-sensitive income trusts will likely come under pressure in a rising rate environment, but that investors need to be reminded of why they bought into a trust-based fund in the first place — for the income. If investors can stomach the drop in NAV, they could expect to see their distributions remain relatively stable.

The trick is coming up with a new and creative way of telling this to investors who have grown accustomed to 20% total returns over the past few years.

To combat a precipitous decline in NAV, Lundquist says it is important to ensure a proper mix within the fund portfolio, avoiding a heavy reliance on the rate-sensitive trusts. Rather than selling these off though, she says steady inflows of new cash can simply be directed into the less rate-sensitive business trusts to alter the portfolio balance.

“When it comes to adjustments made on interest rate changes, the market usually is very efficient and you have to change your portfolio before the rest of market figures it out,” she says. “To try to get there first is very difficult.

Her strategy has been to piece together a portfolio of stable trusts that she can count on for their distributions, while still allowing for some capital growth.

“We’re making sure we don’t batten down the hatches so tight that if the storm doesn’t come, we all suffocate,” she says. “We want to make sure we have some of the more aggressive names so that if rates don’t rise, we don’t miss out on that.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com