The Big Picture
Since mid-2007, the global financial system has been rocked by a credit crunch, spawned by the severe downturn in the extremely overleveraged US housing sector. As America’s closest neighbor and trading partner, Canada, too, has experienced aftershocks. And many of my favorite Canadian trusts have felt the pain.
The good news: The country’s economy is still on firm ground. Its banking system is among the most stable in the world. Its national government continues to run a big surplus. Its balance of trade remains strongly positive and its currency, the loonie, is solid.
As the graph “Under Control” shows, the Bank of Canada (BOC)—the country’s equivalent of the US Federal Reserve—has maintained inflation at a low, steady rate in recent years. That task has been made a great deal easier by the rise in the Canadian dollar, which has pushed down the cost of imported goods and services. But the upshot is the BOC has considerably more flexibility than its US counterpart to cut interest rates and spark growth without igniting inflation, which is critical to the country’s future economic health.
Continuing a decade-long trend, employment is robust. Growth of both jobs and wages has been consistently strong over the past couple years. That, in turn, is fueling steady growth in consumption, as well as a healthy real estate market. As the graph “A Full House” demonstrates, occupancy rates for apartments, office buildings and industrial parks have remained steady the past two years at levels far above those in the US.
As for the banks, they remain “well-positioned to absorb the effects of the recent market turbulence, because of their initial sound capital positions and strong profits,” according to the BOC’s January report. The BOC notes the country’s banks’ “loan-loss performance has been good, and their exposure to the US subprime-mortgage market and to leveraged loans appears to be small and manageable.” And it forecasts “the deterioration in the quality of bank loans should be limited,” even in the face of growing US weakness.
That prognosis stands in sharp contrast to the ongoing implosion of much of the US financial services industry. And the BOC and Canada’s major banks have relentlessly attacked any signs of weakness, dating back to early 2007.
The clearest evidence is shown in the graph “Delinquency Gap.” While US subprime mortgage defaults have soared to double-digit percentages, Canada’s have remained well below 2 percent since the BOC began keeping records in 2002.
Unlike in the US, Canadian banks have consistently confined subprime products to near prime and Alt-A customers, eliminating some of the features leading to the rise in US delinquencies. And market funding of subprime—so prevalent in the US and elsewhere in the world—is considerably moderated by Canadian lenders’ reliance on deposits. Finally, a number of Canadian lenders have stopped providing subprime loans to new customers altogether, further reducing the system’s exposure.
It all adds up to a banking system that’s far healthier than its US counterpart. As the table “Strong Banks” reveals, of Canada’s major financial institutions, the only one currently in hot water with credit raters is Canadian Imperial Bank of Commerce (CIBC). The rest have stable to positive outlooks for their already lofty ratings.
That’s another stark difference with major banks in the US and elsewhere in the world, which continue to write off billions of their previous excesses and likely have much more to come. Canadian banks, excluding CIBC, account for only 1.2 percent of total global asset writedowns and credit losses—including reserves set aside for bad loans. And only CIBC ranks in the top 20 losers.
CIBC’s problems stem almost wholly from exposure to the US real estate market—specifically from US collateralized debt obligations (CDO) based on subprime mortgages. These had been hedged with credit default swaps from either highly rated banks or financial guarantors. Unfortunately, a guarantor of CAD3.5 billion in such swaps has been dramatically weakened financially. That’s forced the bank to take some CAD3 billion in writedowns to date, with more very possible in early 2008.
Even CIBC’s risk, however, appears to be manageable. A new team has taken control with the goal of rebuilding capital quickly. Last month, the bank issued CAD2.75 billion in new equity to that end, diluting its shares but dramatically shoring up its financial health.
Of the four major rating agencies, Fitch and Dominion Bond Ratings Service still have CIBC ratings on watch for downgrade. Fitch, however, has stated that “recent earnings have exhibited improving trends, with a strong performance from the Retail Markets business.” Further, it asserts “traditional asset quality measures remain quite good and liquidity is prudently managed” and expects “CIBC to be able to manage through this situation,” noting the track record of the management team.
Meanwhile, Bank of Montreal is contemplating spending some CAD2 billion to buy assets in the blasted US banking sector, which could potentially include larger institutions. That’s a clear sign that things really are different on Canada’s side of the border, a very good sign for that country’s economy and markets in the troubled environment of early 2008.
Three Challenges
Looking ahead to the rest of 2008, Canada faces three major challenges from a weak US. First, its still heavily dependent on US markets for exports.
As the graph “Key Partner” shows, as of the most recent available figures, US markets are absorbing slightly more than three-quarters of Canada’s exports, with the major portion being energy.
US trade has been key to Canada’s health since the foundation of each as European colonies centuries ago. Given Canada’s much-smaller population and economic base, it’s been far more dependent on its neighbor than vice versa. Dependence actually grew markedly in the 1990s, as the passage of the North American Free Trade Agreement pushed the percentage of exports from the mid-70s to the mid-80s by 1999.
There’s little doubt a prolonged recession in the US would trigger a drop in Canadian exports and, therefore, negatively impact the country’s growth. Realistically, however, the impact would be far less than the Wall Street consensus and investment markets are pricing in.
First of all, the sharp rise in the Canadian dollar during the past several years has already depressed the country’s nonenergy exports by making them pricier relative to US competition. That trend continues to wreak havoc on several trusts, including seafood merchants Clearwater Seafoods Income Fund (TSX: CLR-U, OTC: CWFOF) and Connors Brothers Income Fund (TSX: CBF-U, OTC: CBICF), both of which have stopped paying regular monthly distributions. But it’s hardened the remaining exporters to further weakness.
That leaves energy and commodity exports, which have increasingly found eager markets overseas, particularly in Asia. A closer look at the graph “Key Partner” brings this growing trend into graphic relief. Since early this decade, the US percentage of Canadian exports has fallen from the mid-80s to a recent low in the mid-70s despite a continuing overall rise in Canadian exports to the world. The main reason is surging demand from Asia.
US demand for Canadian oil and gas could well fall if things get really bad here. US demand for oil, however, was roughly flat in the second half of 2007, at the same time prices soared toward the century mark. And although some of oil’s rise has surely been due to “speculation,” a lot of that is due to the fact that Asian demand for black gold is only going to keep growing in coming years.
Chinese demand continued to grow during the ’80s, even as oil demand slipped elsewhere. And China, India and other emerging economies are far more important players than they were a quarter century ago. Even a drop in US demand for energy isn’t a sure thing this year, particularly with the Fed aggressively slashing interest rates to prevent a recession. Moreover, oil sands exports to the US are in a decided uptrend that’s set to continue regardless.
For its part, the BOC projects a lower outlook for Canadian exports, specifically “reflecting the weaker US economic outlook.” The expected impact on overall growth in GDP, however, is a mere tenth of a percentage point for an overall GDP growth rate in 2008 of 1.8 percent. That rate of growth is projected to accelerate into 2009, with exports to the US and elsewhere again contributing a healthy percentage.
Of course, even central bank projections are meant to be broken, and the current ones represent a slight mark down from those made last fall. But they do demonstrate confidence in the face of US weakness that would have been impossible even a decade ago. Clearly, this isn’t the Canada of yesteryear.
The second major challenge facing Canada concerns the Canadian dollar itself. With the US Fed slashing interest rates to the bone to prevent recession and oil prices still stubbornly close to the century mark, it’s tough to envision a scenario where the currency won’t be strong in coming months. And Canadian debt also enjoys a healthy yield premium to US debt, further inviting cross-border investment.
Part of the solid return many Canadian trusts posted in 2007 was due to the rise in the loonie, which pushed up the US dollar value of trusts’ distributions as well as share prices. The loonie’s surge, however, had a decidedly negative effect on cash flows of many trusts, starting with exporters but also including oil-producing trusts, which saw the rise in black gold somewhat offset by the corresponding boost in the currency.
The dilatory impact of the loonie’s rise hasn’t gone unnoticed by the country’s politicians. To date, the Harper government has backed up the BOC’s policy of not fixing the currency’s value to the US dollar. The bank, however, has an assumed trading range of 95 to 98 US cents per loonie. That’s below the current level and will require the bank to cut rates further to maintain.
The good news is rate cuts should help the Canadian economy and markets without really cutting into the US dollar value of good Canadian trusts, which should be more than offset by rising share prices. The bad news is, as long as the US dollar stays weak, it’s going to be tough on Canadian exporters, particularly those outside the energy sector.
Ironically, the third challenge is the credit crunch, which, despite the general good health of Canada’s banking system, does pose a threat to more than a few Canadian corporations and trusts. The reason is simply availability of credit.
As in the US, BOC rate cuts will go a long way toward easing pressures on lenders, and the strength in the Canadian dollar gives the central bank a lot of room to maneuver. In addition, mortgage rates have held reasonably steady, and there’s no overhanging adjustable-rate mortgage problem on the scale of the US either.
Nonetheless, credit spreads have widened in Canada as the global crunch has deepened and worries about banks elsewhere have spread. In its January 2008 policy report, the BOC noted money market conditions temporarily worsened in late 2007 with spreads between three-month Interbank offered rates and Overnight Index swaps widening out to 80 basis points before plunging back to October levels in early 2008.
That, of course, was far less severe than what happened in the US or Europe. But it still had the impact of making money more expensive at the time year-end funding was needed.
The spread between A-rated Canadian corporate bonds and Canadian government bonds—with equivalent maturities and conditions—has now widened to 140 basis points from 100 in October. Meanwhile, the spread between effective household borrowing rates and the overnight lending rate has increased roughly 20 to 25 basis points, and the similar spread for nonfinancial firms has increased 15 to 20 basis points since October.
Coupled with the rise in yield spreads in the bond market and tighter conditions for bank loans and market debt, that adds up to “a significant tightening in credit conditions faced by firms,” according to the BOC. Looking ahead, the central bank doesn’t expect serious problems this year for companies with strong ongoing banking relations seeking credit. It does expect the cost to be higher, but the impact on investment is projected to be near term not long term.
On the other hand, it has sounded a cautionary note for those seeking funding for “risky transactions,” including leveraged mergers and acquisitions. This has already been felt in the trust sector by the sharp drop takeover activity since mid-2007, and it’s likely to continue depressing deal making at least into the second half of 2008.
Before the credit crunch really took hold, a number of individual Canadian trusts had initiated “strategic reviews,” many of which were expected to end in takeovers. Over the past few months, almost all of these have been put on hold to wait for better market conditions. And with very few exceptions, they’re likely to stay that way until credit gets easier to obtain.
That’s not a problem for stronger trusts that can otherwise operate on their own indefinitely. But it’s reduced the potential for trusts not measuring up to their stress tests to be bought out at anything resembling a good price. And investors holding onto weak trusts in hope of a takeover are now faced with the growing prospect of riding out a death spiral.
Given the volume of Canadian trusts selling near book value—and the growing number demonstrating their strength by raising distributions in the past year—I fully expect takeover activity to resume with a vengeance, probably in the second half of 2008. But until credit conditions improve, only very well-heeled would-be acquirers—such as sovereign-backed entities like Abu Dhabi’s TAQA—will bother taking the plunge.
Even these buyers will be choosing targets very carefully, given greater government scrutiny of foreign takeovers of Canadian-based businesses. That doesn’t diminish the appeal of the first-rate trust takeover bets I highlighted in the January Feature Article. After all, I want to hold them even if no deal occurs. But it does mean we, like trusts’ managements, will need to be patient now in order to cash in when activity does accelerate.
Thriving on Stress
In the December 2007 Feature Article, I focused on the “stress tests” Canadian trusts have literally faced since mid-2006. The trouble began with the relentless decline in natural gas prices since the aftermath of hurricanes Katrina and Rita, resulting in the virtual shutdown of Canada’s gas patch and severe damage in particular to small, natural gas-producing trusts and energy service trusts.
The stress test continued with the surging Canadian dollar’s negative impact on manufacturers and exporters that compete directly with US rivals. They accelerated with the Halloween 2006 announcement that Canadian trusts would be taxed as ordinary corporations beginning in 2011 and the subsequent drying up of equity offerings because of restrictions on new share issues and plunging prices.
As 2007 wore on, weaker trusts were increasingly forced by these pressures to slash distributions, sending their prices lower still. And more than a few have been unable to continue operating as businesses because of their inability to access capital markets. Those not rescued by takeovers—such as Penn West Energy Trust’s (NYSE: PWE, TSX: PWT-U) buyout of Vault Energy last month—have literally entered a death spiral.
The ongoing global credit crunch is the latest and potentially greatest of this series of stress tests affecting the trust sector. The dangers I’ve pointed out above are very real and have already taken a toll on trusts’ share prices thus far in 2008, including several of those that rang up huge gains for us last year.
Ironically, aside from the trusts that were failing already, this stress test has to date claimed only one victim from a business standpoint: CI Financial Income Fund (TSX: CIX-U, OTC: CIXUF). As pointed out in the Jan. 29 Maple Leaf Memo, CI has trimmed its distribution from a monthly rate of 18.33 cents Canadian to 16.5 cents Canadian. That’s only a 16 percent reduction, and the trust looks well positioned to maintain that rate.
The cut, however, does demonstrate the increasing uncertainty in the trust’s wealth management business and pressure on its assets given the current equity market turmoil. Moreover, it shows pretty clearly the vulnerability of trusts paying out 95 percent or more of cash flow that operate outside the power generation or REIT sectors.
I still view CI Financial Income Fund as a solid enterprise and a buy. But investors should note the number of names on the Dividend Watch List this month.
CI Financial isn’t a Canadian Edge Portfolio holding. And its nature as a financial services firm with an asset base closely tied to stock values makes it uniquely exposed to the pressures of the credit crunch. But this move by a trust that had recently increased its distributions—13.4 percent over the past year—is a pretty clear sign of the importance of the fourth quarter earnings season, which begins in earnest in mid-February and will run through mid-March.
As I stated in the Jan. 23 flash alert, A Rough Start, I look for Portfolio holdings’ results to be broadly reassuring that all are still operating strong, growing businesses. For one, my favorite power generation and energy infrastructure trusts continue to operate in what’s still a very robust market, illustrated by the strong results posted by virtually every US electric utility operating in unregulated markets and still solid US energy demand. Power trust payout ratios, in particular, should move down markedly on seasonal factors alone, including Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF).
As the graph “A Full House” made clear, Canadian REITs continue to operate in a very healthy environment. Moreover, I originally added the likes of Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF), Northern Property REIT (TSX: NPR-U, OTC: NPRUF) and RioCan REIT (TSX: REI-U, OTC: RIOCF) precisely for their ability to weather a much-weaker environment for Canadian property than what currently exists. Artis REIT (TSX: AX-U, OTC: ARESF) operates mainly in the energy-rich West, which continues to boom.
Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF) operates a virtual utility-like business, with no exposure to the troubles in the US. Energy Savings Income Trust (TSX: SIF-U, OTC: ESIUF) should be equally immune to recession, given that the electricity and gas it sells are essential services and the fact that it operates under long-term contracts. And although Arctic Glacier Income Fund (TSX: AG-U, OTC: AGUNF) may be pressured longer term by a weaker US dollar, ice sales aren’t a cyclical business either.
That leaves GMP Capital Trust (TSX: GMP-U, OTC: GMPCF) and Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF) as the only Conservative Portfolio trusts that may have some vulnerability to the aftershocks of a US crunch. Yellow, however, operates a literal monopoly of print directory service in Canada.
And despite the weakness of US directory companies in recent months, there’s no sign whatsoever Yellow won’t post solid fourth quarter print ad revenue, even as it continues to transition business to the Internet. As for GMP, it’s fundamentally a far different business than CI Financial, with a lot more ability to profit during battered markets.
In theory, the Aggressive Portfolio holdings should be the most vulnerable to an economic downturn, given the risk of a sharp drop in oil prices. Ironically, this is the group whose fourth quarter results should really shine and stay on the upside in 2008 as well. The reason: Up through the third quarter of 2007, it was selling its oil for some $20 per barrel below spot prices. Combined with firmer natural gas prices and a slightly lower Canadian dollar, that should translate into higher cash flows in the fourth quarter and lessened perceived risk in the marketplace as their payout ratios drop and share prices rise.
Energy services trusts will take longer to come back. But as the Portfolio section points out, Trinidad Energy Services Trust (TSX: TDG-U, OTC: TDGNF) has turned itself into a beneficiary of its sector’s weakness.
That leaves Newalta Income Fund (TSX: NAL-U, OTC: NALUF) and TransForce Income Fund (TSX: TIF-U, OTC: TIFUF) as the wildcards. Both, however, were certainly on the right track as recently as the third quarter, and my bet remains they’ll come through in the fourth. Newalta, for example, has already announced an aggressive 2008 capital spending plan that’s heavily weighted toward growing its business lines. And TransForce successfully completed the Thibodeau purchase last month.
As always, I’m going to listen to what the numbers tell us. And any of these trusts—no matter how much I like them now—will get the axe if they fail to measure up. As long as they do, however, recovery is assured as the macro picture brightens, as it will later this year. Meanwhile, here are four factors I’ll be looking for as announcements come out:
Business Strength and Growth—A growing business is the best defense against both credit risk and inflation risk for any income investment. If a trust can meet its strategic goals under the conditions that have prevailed in the past year, nothing is going to stop it going forward.
Dependence on Outside Capital—I don’t want to see much growth in either the number of a trust’s shares or its debt unless there’s a very good reason for it, like the expansion of a cash-generating asset or an acquisition. Absent that, I’m out.
Distribution Coverage and Consistency—Sustaining distributions is the ultimate goal during a trial by fire. The key metric is the payout ratio, or total distributions as a percentage of distributable cash flow. The How They Rate Table key shows the maximum ranges allowable for safety in each sector.
Costs and Margins—A trust may not be able to grow cash flow robustly every quarter because of factors beyond its control. But if it’s controlling costs and holding operating and profit margins steady, it will ultimately shine when macro conditions improve. Conversely, if a trust is just benefiting from a favorable macro trend and running a sloppy operation, I’ll be out.