Trust wall collapses

Until late January, a huge wall had separated the burgeoning income trusts sector from the rest of the listings on the Toronto Stock Exchange – our own financial version of the Berlin Wall, if you like.

Then on January 27 that wall came crashing down, almost as suddenly and surprisingly as its German counterpart. After years of lobbying by the industry, Standard & Poor’s capitulated and announced that income trusts will be included in the benchmark S&P/TSX Composite Index by mid-year.

Currently, there are 175 income trusts in Canada with a market capitalization of about $123 billion. An earlier S&P study estimated that 56 trusts would qualify for inclusion in the Composite Index, based on market cap.

Complete details have yet to be announced. At this point, we don’t know how many trusts will actually make it into the Index or whether they will all be incorporated at once or gradually over time. S&P also said it will create a new, corporations-only index and it will be interesting to see what degree of status it attains among investors and whether some index funds will switch their benchmark to it rather than add income trusts to theirix.

Implications for investors
But no matter how this plays out, the move will have huge implications for both the sector as a whole and for individual investors. One immediate impact will probably be to drive up the prices of trusts that are expected to be included in the Composite Index, which is not great news at a time when market values already look expensive.

Guardian Capital, which manages several funds that specialize in income trusts, issued a statement describing the announcement as “very positive for the sector” and saying it “may lead to significant investment by institutional investors in income trusts listed in the S&P/TSX Composite Index”.

That certainly appears to be a likely development. Those index funds that continue to use the revamped TSX Composite as their benchmark will have to add income trusts to their basket in order to maintain proper tracking. Pension fund managers will also be more likely to increase their trusts weightings as a result of this move. The recent approval by the Ontario government to extend limited liability to unitholders will also lessen resistance to adding trusts to pension plans.

Ottawa’s options limited
Finance Minister Ralph Goodale, who tried unsuccessfully last year to limit pension plan ownership of trusts, must be watching all this with a furrowed brow. The S&P announcement makes it much more difficult for him to undertake any new initiative to curb the growth of this sector and the potentially growing tax drain that he fears. Any action by Ottawa to limit investor participation in what will become a key component of the S&P/TSX Composite would be viewed by the investment community both here and in the U.S. as unacceptable governmental intrusion into the operation of the financial marketplace.

Individual investors will react according to whether they are owners or potential buyers. Those who already have substantial positions in trusts that are likely candidates for inclusion in the revamped Composite Index will be able to sit back and relax. Barring other influences, the market price of their shares will probably rise in the coming months.

However, those who would like to get into this sector or to add to their positions are faced with the prospect of paying what appear to be inflated prices for the blue-chip trusts or looking elsewhere. The result could be to focus more attention on the mid-size and smaller trusts which will not qualify for the Index, although bargains are increasingly hard to find there as well.

In short, the fall of the wall is a mixed blessing, just as it was for the Germans who are still trying to integrate the old East Germany into the national economy more than a decade later. But, as with the Berlin Wall, this move was inevitable. We will now have to adjust our strategies to the new reality.