Are income trusts overheating?

There are some worrisome signs in the hot income trusts market.

During November, brokers were selling at least 15 new public offerings for closed-end funds that will focus in whole or in part on the income trusts sector. They expected to raise some $500 million in new capital.

Many of these funds, which will trade on the TSX, are sponsored and managed by traditional mutual fund companies in what may be a sign of the times. They include Sceptre Investment Counsel, Mackenzie Financial, Covington Funds, and Montrusco Bolton.

Forced to buy at the top?
Here’s the problem. Income trusts are already trading at very high levels. The S&P/TSX Capped Income Trust Index was up 12.5 per cent for 2004 to Nov. 29 and was trading near its all-time high. This means that the new funds are going to be buying near the top of the market when they open for business.

They can’t just sit on the sidelines and wait for prices to drop because investors will be looking for cash flow. So the managers will have to take positions. The short-term effect may be to drive the already high prices even higher. But longer term, I see trouble brewing.

Intere rates continue to rise. The U.S. Federal Reserve Board hiked its key rate by a quarter-point at its last meeting and many economists think it will move again in December, making it five rate increases in 2004. The Bank of Canada also appears poised to raise rates again.

Rising interest rates are not good news for income trusts because they tend to narrow the margin between their yields and those of rock-solid government bonds. Unless a trust can continue to raise distributions, the odds are that eventually its market price will pull back so as to maintain the spread with government bonds.

We saw an example of this in the spring when interest rate fears caused the trust market to retreat substantially. However, that turned out to be an overreaction and prices of most trusts recovered quickly. Things could be quite different the next time around.

Time for a correction?
This is not a prediction that the trust sector is heading for a collapse. Rather, we could be on the verge of the type of correction we’ve come to expect from stocks when the market gets ahead of itself.

I can’t predict the exact timing because it may be distorted by the demand from these new funds and RRSP season, but I expect a broad pull-back before spring.

The end result is likely to be a decline in the net asset value and the market price of the new closed-end issues now coming to market. Frankly, I can’t recommend purchasing any of them under these conditions and I know of some brokers who are telling their clients exactly that, even though their firm is in one or more of the underwriting groups.

“I’m on a buyer’s strike right now,” one broker told me in confidence.

Existing funds will also be hit in any correction, but they at least have the advantage of having been able to take positions at a time when the prices were lower. The new kids on the block won’t be in that situation.

So if your advisor calls to extol the virtues of these new offerings, thank him or her politely and say that you’ll wait and see. I expect you’ll be able to buy shares more cheaply in a few months.