Rate risks can be mitigated: Income managers

(April 28, 2005) The markets have been anticipating higher interest rates from the Bank of Canada for several months now, with rate sensitive sectors showing increased volatility as scheduled announcement dates near.

Income investing has been all the rage since the technology meltdown at the turn of the millennium, so the threat of higher interest rates may be a source of anxiety for many investors.

The sector with the greatest exposure to rising rates is the bond market, where traders have been focusing on short-term assets in anticipation of a rate increase. Yields for the 10-year Canadian bond have been compressed to about 4.12% (as of April 28, 2005), while the 30-year is offering an additional 46 basis points.

In a recent webcast hosted by Bissett Funds, Guy Leblanc, lead manager of Bissett Bond Fund and co-lead of Bissett Short Term Bond Fund, says these rates are not as low in historical terms as some investors might think.

“Bond investors only remember the past 20 years or so, thus yields today look very low, when it isn’t so,” he says. “The 10% to 15% yields of the ’80s were an anomaly. The yields of the ’80s were one, two, even three standard deviations above the 50-plus-year average. Although we’re currently below the bond yield averages of the past 50 years, we’re in line with the yields of the ’60s and above those of the ’50s.”

If the Bank of Canada were to launch a credit tightening program this year, traders could be expected to at least partially liquidate their positions in order to buy newer bonds with higher coupons. The sell-off would lower the trading price of existing bonds, thus raising their yields.

The central bank would only embark on such a tightening cycle if the Canadian economy were showing signs of overheating, as the move would serve as a catalyst for a stronger Canadian dollar.

“The Canadian economy is not that strong and exports are slowing down because of the strong Canadian dollar,” Leblanc notes. The only areas demonstrating such strong economic activity are China and a few Southeast Asian economies, while the U.S. and Europe should lag.

“We don’t expect yields to go up too much from the current level,” Leblanc adds. “I’d like to remind everyone that bonds are not really in the portfolio to shoot the lights out, but they will minimize volatility and provide a safe harbour if and when equity markets turn.”

On the equity side, Juliette John, lead manager of Bissett Dividend Income Fund and co-lead manager of Bissett Income Trust and Dividend Fund, says interest rates will likely rise in Canada more slowly than in the U.S., as America aggressively attempts to stave off inflation. She doubts the Bank of Canada will make any move before the third quarter at the earliest.

“That said, the negative relationship between P/E multiples and interest rates will play a role as we go through the ’05-’06 period, if even only based on the perception that rates will rise,” she warns.

The mere expectation of rising rates should drive short-term yields higher and John estimates the 10-year Canada bond will be sold off, driving the yield from its current 4.14% to about 5% by year’s end.

While many consider current bank stock valuations to be a little high, John points out the banks are trading with a dividend yield roughly equal to 75% of the 10-year Canadian bond yield. A ratio of less than 60% is typically seen as a “buy” signal, so bank stocks remain reasonably valued in today’s market.

And while the banks appear to be underpriced by this metric, she points out the sector as a whole is sitting on a tremendous amount of capital, with a diversified earnings base.

“We’ve got the sector trading at below 12.5 times earnings and yields at over 3%, which supports that yield to bond yield relationship,” says John. “This is a great example of a sector that is discounting material movements in interest rates, despite ignoring some sound fundamentals.

“Short-term volatility could absolutely materialize and we would view that as a buying opportunity.”

Historically, dividend-paying stocks offer far less volatility than those which do not pay out their cash and offer superior compound returns on a long-term basis. In the current slow growth market environment, John points out that dividends become an even more important component of total returns.

With dividend stocks typically being the strong, stable members of an index they can often demonstrate a certain level of tolerance to rising rates, behaving in a more economically sensitive manner.

This makes them a good counter balance for rate sensitive holdings in a portfolio, including some of the income trust universe. Utility trusts — often referred to as “pipes and power” — tend to fall into this category, while oil and gas royalty trusts and many business trusts tend to be more economically sensitive.

“If rates do go up, certainly the income trust market would be exposed to that and I’m not going to try to pretend that we could fully get away from that,” says Leslie Lundquist, lead manager of Bissett Income Trust and co-lead of Bissett Income Trust and Dividend Fund. “All investors care about what interest rates do. However, we think some trusts will be more rate sensitive than others.

“The income trust pullback we saw earlier this year was largely due to interest rate fears.”

Currency exposure is a secondary risk for trusts which derive their income from the U.S. market. Should the American dollar continue to weaken, the distributions of U.S.-based trusts will suffer, even if the underlying business operation remains strong.

Lundquist says currency hedging can buy the trust some time, but that such a strategy is ultimately a short-term fix, simply deferring the pain to the end of the hedging contract.

“These companies have to be productive enough to operate their U.S. businesses to squeeze out Canadian dollars to their holders,” she says. “On the bright side, if you are concerned about currency fluctuations, most trusts are focused on the Canadian market and relatively few are exposed in any significant way to the U.S. dollar.”

Lundquist admits that trusts are quite pricey at current valuations, pointing out that the market is no longer at its peak, but it is not particularly inexpensive, either. She notes that the trust sector is massively overweighted toward commodities — a sector which is currently at the top of its cycle.

“I don’t think there are any pockets of undervaluation left in this market. Trusts for the most part are priced for perfection, or even better than perfection,” she says. “Of course, we know there is no such thing as a perfect company — glitches can and do occur and we’re going to see that happen to some of the trusts.”

Others see far greater concerns, especially in the newer business trust segment. Dr. Al Rosen is a forensic accountant at Accountability Research Corporation, an equity advisory firm in Toronto.

“I think it’s safe to say that probably half of the business trusts are worthy of extensive investigation, let’s put it that way,” he says, calling them little more than well-hyped pyramid schemes.

According to his firm’s research, many of these companies are under-reporting the percentage of their distribution which should be considered return of capital, leaving it taxable as return on capital.

“If you’re paying people back the $10 or so that they paid per unit, and you pay them back bit by bit over a dozen years, they end up paying tax on their own money coming back,” he explains. “You have a whole bunch of them saying the return of capital is zero. The securities commissions and the auditors should know this is pillaging the retirees, but they remain silent.”

Rosen blames Canada’s relatively lax accounting rules, allowing the companies to pick and choose what falls into the expense column. Too often they do not include their full capital depreciation costs.

“Why is Canada doing all of this, but other countries aren’t?” he asks. “The CAs, the auditors and the securities commissions are ignoring all of this pro forma accounting, as they did with Nortel.”

Rosen agrees that there are legitimate income trust investments available, largely in the traditional sectors, including REITs, utilities and even the oft-maligned oil and gas royalty trusts.

“There are some trusts that have been around for a long time, that have reliable, steady cash flow. I haven’t any quarrel with those,” he says. “We’ve always known that the oil and gas depletion is something you disregard as an investor, because when the oil and gas is depleted, that’s the end of it. You know, being in that business, that you’re going to get back a chunk of your own capital. It appears on your tax T3.”

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Dr. Al Rosen will be speaking at the Peel Institute of Applied Finance Toronto Spring Symposium, May 17 & 18.

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

(04/28/05)

Steven Lamb