The crunch in the US mortgage market continues. And, as today’s news indicates, at least some Canadian financial institutions have exposure.

The risk to well-run Canadian income trusts, however, remains markedly low. That also includes Canadian real estate investment trusts (REITs), which continue to benefit from a strong property market, higher occupancy rates and more conservative financial policies than their US counterparts.

As I wrote in the August issue of Canadian Edge, trusts’ exposure to what’s still pretty much a US phenomenon basically boils down to two areas. First, the pace of trust takeovers has slowed in the past few weeks. None of the ongoing deals have been pulled as yet. But it’s likely some of the trusts undergoing strategic reviews may elect to remain independent, at least for the time being.

The primary reason is most trust takeovers—at least those outside the energy patch—have been paid for in cash. That means borrowing from banks, and credit has dried up for now.

I don’t see this as a long-term trend. The basic appeal of trusts as cash cows is undimmed. These are solid, growing businesses that generate a lot of cash flow. Also, management is still willing to sell for the right price.

As I stated in the August CE, I didn’t see the pause in takeovers as a major threat to trust share prices. The fact that most deals were going off at steep premiums to pre-announcement prices was a pretty good indication that few had been bid up in anticipation of a deal. That remains my contention now, though if one of the ongoing takeovers should collapse, it would hurt the targeted trust.

Gas Still Key

The other point of exposure concerns the extent to which trust cash flows are affected by further weakness in energy prices, particularly natural gas. We now have second quarter results for producers, as well as energy service trusts.

As has been the case in prior periods of weakness, the core of the Aggressive Portfolio—which is designed to bet on Canada’s energy patch—fared reasonably well, thanks to balanced production, long-lived reserves, strong balance sheets and conservative payout policies. Payout ratios rose slightly as is customary for the second quarter, which is seasonally a slow time for the sector. But distributions remained well covered and, more important, gave every indication they will be the rest of the year, even if energy prices remain volatile.

That applies to ARC Energy Trust (AET.UN, AETUF), Enerplus Resources (ERF.UN, NYSE: ERF), Penn West Energy Trust (PWT.UN, NYSE: PWE), Peyto Energy Trust (PEY.UN, PEYUF), Provident Energy Trust (PVE.UN, NYSE: PVX) and Vermilion Energy Trust (VET.UN, VETMF). It also applies to energy services trust Trinidad Energy Services Income Trust (TDG.UN, TDGNF), which, despite selling off, posted solid rig rates that remained well above industry averages and a payout ratio of just 60 percent year-to-date.

The exceptions, as I feared, were the selections most leveraged to natural gas. As I pointed out in the August issue, as well as Flash Alerts last month, Paramount Energy Trust (PMT.UN, PMGYF) and Precision Drilling (PD.UN, NYSE: PDS) both already trimmed distributions prior to releasing results. At this point, both appear to have made the needed adjustments and should be able to maintain current payouts this year.

Again, that’s contingent on gas prices. A further plunge in prices could trigger another distribution reduction. On the other hand, a rebound in prices and these trusts should be off to the races. That’s why we own them.

In the middle are Newalta Income Fund (NAL.UN, NALUF) and Advantage Energy Income Fund (AVN.UN, NYSE: AAV). Despite its focus on natural gas, Advantage still managed a payout ratio of just 83 percent in the quarter, on the strength of production gains, debt reduction and solid hedging.

The upcoming merger with Sound Energy Trust (SND.UN, SNDFF) is slated for a vote next month, which should further add scale and ability to weather the difficult price environment. But again, Advantage is weighted to gas and, though not as at risk as Paramount and Precision, is still affected by price swings in the fuel. That could be a huge positive in coming months.

As for Newalta, second quarter earnings again highlighted its dual nature. On the one hand, its environmental cleanup/remediation operations in eastern Canada continued to grow rapidly, with both revenue and margins doubling in the past year. On the other, energy patch operations were hit again by the slowdown in natural gas activity because of less drilling, as well as poor weather conditions. 

The result was overall cash available for growth and distributions again lagged actual distributions. In the third quarter, a good part of that should be worked out by the normal seasonal pickup in energy patch activity, as well as continued growth in the east. Obviously, however, there will have to be improvement in order for the current distribution level to hold.

At this point, the board has maintained the current distribution rate in anticipation of a recovery in cash flow in the second half of 2007. In addition, Newalta shares have come down pretty hard in the past few months on the energy patch weakness and are arguably pricing in a reasonably large dividend cut already.

In my view, that mitigates the risk from continuing to hold this once highflier, particularly considering its strengths and ability to grow when normal conditions return to its markets. Until the numbers improve, however, there will be dividend risk. That’s why it’s in the Aggressive Portfolio.

The Rest

The Conservative Portfolio trusts haven’t been wholly spared the turmoil of the past several weeks. Some, like Boralex Power Income Fund (BPT.UN, BLXJF), may have taken a hit because of the perception that its strategic review is less likely to result in a high-profile takeover in the immediate future because of turmoil in the credit markets. (See above.)

To a trust, however, the Conservative holdings did turn in solid second quarter numbers. Boralex’s numbers were trimmed a bit by weaker hydro conditions, and its payout ratio moved above 100 percent.

Volatility in hydro one quarter, however, is typically balanced out the next ,and the trust covered the payout handily on a six-month basis. Boralex Power Income Fund is still a solid buy and very attractive, yielding nearly 10 percent.

Earnings standouts included Algonquin Power Income Fund (APF.UN, AGQNF), which rebounded from a weaker first quarter on strong asset performance. Macquarie Power & Infrastructure (MPT.UN, MCQPF) belied the bad press its parent has been getting and turned in solid cash flow gains. So did Atlantic Power Corp (ATP.UN, ATPWF).

Pembina Pipeline Income Fund (PIF.UN, PMBIF) blew the doors off with its second quarter results, allowing management to increase its dividend another 9 percent. Energy Savings Income Trust (SIF.UN, ESIUF) came up big, spurring another dividend increase, and AltaGas Income Trust (ALA.UN, ATGFF) put itself in position for one as well, though it may elect to plough back more funds into growth. So did Keyera Facilities (KEY.UN, KEYUF).

Arctic Glacier Income Fund (AG.UN, AGUNF) came in with record second quarter results. So did Yellow Pages Income Fund (YLO.UN, YLWPF).

Meanwhile, Bell Aliant Regional Communications Income Fund (BA.UN, BLIAF) turned in steady gains, as broadband business offset a minor loss in basic rural phone connections. And our real estate investment trusts RioCan REIT (REI.UN, RIOCF) and Northern Properties REIT (NPR.UN, NPRUF) rode continued strength in Canadian property and wise management stewardship to strong cash flow gains. Even TimberWest Forest Corp (TWF.UN, TWFUF) turned in a solid result, despite the impact of a strike.

The bottom line is all of these holdings met our primary criterion for remaining in the Conservative Portfolio: solid business growth. All are on track to continue paying high, reliable distributions, regardless of what happens in Ottawa before and after 2011.

Nothing is completely protected against what might happen in global markets. Should the US mortgage crisis become a full-blown word credit crunch—as Asian economic turmoil triggered in 1998—not many investments are going to avoid taking on at least some water. And given that we’re still so close to last Halloween, trusts are still suffering from a misperception of risk.

These trusts, however, show every sign of being able to continue growing, generating big cash flow and paying big dividends for the rest of the year and beyond. In addition, these aren’t highly leveraged situations either that depend heavily on credit markets.

Rather, like all trusts, they’ve already pulled in their horns in response to Finance Minister Flaherty’s restrictions on growth. And prior growth was financed primarily not by debt but by issuing new shares, which was cheap to do before Halloween 2006. As long as that’s the case, we’ll be hanging onto them through the ups and downs.

No one can say for certain how the market will treat trusts in coming months, particularly if the US credit crunch goes global. But it’s worth noting that the roughly 10 percent decline in the S&P Toronto Stock Exchange Trust Composite Index from its June high—which incidentally topped pre-Halloween 2006 levels—is very much in line with the drop in US utilities from their all-time highs this year. And the drop is far less than other income investments, such as high-yield bonds and US REITs. Moreover, the Trust Index drop also reflects the dip in natural gas prices over that time, which has been dramatic.

Hold your positions in good trusts. Note, however, there are still a dozen trusts rated sell in How They Rate. They’re not good trusts and should be sold.

I’ll have more on trust earnings in the upcoming September issue. Note that my colleague David Dittman and I have been reviewing results for all covered trusts on a weekly basis in Maple Leaf Memo, along with developments in credit crisis and other areas. Please sign up to receive these weekly e-mails, which are complimentary with your subscription.

Roger S. Conrad
Editor, Canadian Edge