Stability ratings lead to more questions about income trusts

(January 26, 2004) When the leading bond rating agencies start issuing reports on an obscure investment product, it is understandable that some confusion may arise.

Ronald Charbon, director of Canadian ratings at S&P, realizes the S&P stability rating system may contribute to the confusion over the status of income funds, but he points out unitholders’ interests are subordinated to debt-holders’, leaving little room for misinterpretation.

“It’s a kind of high-yield, small-cap market, but it’s definitely equity,” Charbon told the attendees ofthe Canadian Institute’s Third National Summit on Income Trusts. “In an increasingly complex income fund universe, stability ratings are one way investors can get an independent, third-party view on the sustainability and variability of distributions income funds are paying out.”

He says stability ratings seem to be mistaken as credit ratings — perhaps understandably, since S&P is best know for this service. As a result, some investors may be scared off by the more volatile ratings.

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Charbon says that a low stability rating, such as SR-5 or -6, does not mean the trust is on a par with junk bonds. Nor does an SR-2 rating translate to “investment grade.” The ratings simply indicate the stability of the distribution offered by the fund.

“We have no distinction between a ‘good’ or a ‘bad’ rating. We’re not saying SR-1 is better or worse than the others,” he said. “What we’re saying is with an SR-1, you’re going to have much less variability in your distribution. With SR-6 you’re going to have fairly wide variability of distribution. It’s not a matter of good or bad, it’s a matter of what kind of risk you’re taking.”

He reminds investors that the stability ratings simply pertain to the risk of distribution cuts. It is up to the investor to decide how much of a role that risk plays in valuation of the fund.

But it’s not just the retail investors who are confusing the ratings system. Charbon says any income funds are striving to achieve the SR-1 or SR-2 ratings before coming to market, because they believe it is a sign of quality.

There are actually very few funds that fall into the high-stability rating, which does not necessarily mean they are above-average investments.

“The largest group of income funds falls in our SR-4 category, which is a medium variability and moderate risk category,” he said.

Charbon says there are several other misconceptions about the S&P ratings, including mistaking the rating as a reflection on growth. He said that while his firm does look at growth potential in assessing stability ratings, they are content to leave “buy and sell” ratings up to equity analysts.

“We’re just providing opinions on cash flow, we’re not giving investing advice,” said Charbon. “We think there’s a need for analysis beyond just yield, we think there is a need for independent and unbiased research.”

Further adding to the confusion over the ratings system, the Canadian Securities Administrators has proposed a rule which would require income funds to have a stability rating or explain on the front page of its prospectus why it does not have one.

Despite the potential boon for his company, Charbon says S&P does not support the regulatory use of stability ratings.

He says the rating process can only work properly if the trust is completely open and co-operative with the researchers working on assigning the rating. If stability ratings became a regulatory requirement, rather than voluntary, he says it would become more difficult for the researchers.

“The starting point for this whole process is the operational stability assessment,” he said. “Here is where we really look at expense risk and revenue risk — we focus on the business itself. What are the characteristics of this business or its ability to consistently churn out cash they can distribute to unitholders.”

Too many people also mistake the rating as a probability of default, as with bonds. Charbon points out that since the distributions are not debt obligations, it is not possible to “default” on their payment. Like a traditional equity dividend, the distributions are voluntary.

He says there is too much emphasis at the retail level on the distribution, rather than on the top line income figure for the underlying business.

“If you understand the business and you get a sense of how variable that distribution coming into your account every month is, it’s a very useful complement to the other investment analysis that you have to do,” he says. “Then you’re much farther ahead in understanding what the value and utility of these investments are.”

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What do you think? Do stability ratings make the income trust market any clearer? How important are these ratings in making an investment choice? Share your thoughts about this topic in the Talvest Town Hall on Advisor.ca.

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

(01/26/04)

Steven Lamb