Overview

Under the aegis of the US Federal Reserve Board in recent years which has focused almost entirely on achieving short term goals no matter what the long term costs, macro economic analysis seems quite out of fashion in North America and therefore we may not recognize major risks to the long term health of our economy through short-sighted policies, some with potentially lethal consequences. The US Fed is on a particularly dangerous course of action through its current (well-articulated) policy of artificially hyping up asset prices, by using unrealistically low interest rates, to supplement the rather barren savings larder of the average consumer in order to prolong the expansion which has gone on, virtually without a hitch, for over 10 years. The Law of Unintended Consequences has yet to fully intervene in what on the face of things would seem to be a well-intentioned policy, but the recorded history of similar policies in the past have all led to very unhappy endings. The collapse of the high tech bubble has already given us a foretaste of what we might expect, however. While Canada has wisely chosen not to emulate the United States in this regard, Canada is not immune from the collateral effects of misguided US policies. Consequently, among other distortions in our economy, we have our own home-grown macro economy-killer in Canada: the income trusts. Benign on the surface, they are cancerous below (in the direct sense of the term). In our opinion, the sooner the Federal government puts them to rest, the better. Unfortunately, recent statements by Ottawa only attack the most benign of symptoms of the income trusts, their tax consequences, without an apparent understanding of the real malignancy which they represent.

In brief, income trusts are stupid economics. They may enrich investment banks, allow corporations to sell (over-priced) assets, and benefit investors seeking income and capital gains in the short run, but from the macro perspective, they will lead to national impoverishment by boosting consumption at the expense of capital investment. They do so by the conversion of long-term capital into current income, which will leave future generations substantially worse off than we are today. As attractive as they may appear to be in bridging the need for more income against a background of very low yields, what makes no sense in macroeconomics cannot make sense in microeconomics.

Background

We expect, as do many others, that the policies of the US Federal Reserve Board are leading to yet another asset price bubble. The current bubble is propelled by the desire of the Fed to boost asset prices, which it hopes will lead to sustained strength in consumer spending, and in the end, hopefully to a capital expenditure boom. In other words, the Fed is hoping that consumers will spend their way to prosperity, high asset prices being the key because consumer savings in the US are virtually nil and therefore a standard business cycle is out of the question. In the process, the Fed has driven interest rates down to extremely low – indeed, artificially low – levels and with low rates have come falling yields on both bonds and stocks. Canada, through our intimate interrelationship with the American capital markets has been a short term beneficiary of the current asset price boom in the stock, bond and real estate markets, as well as very low interest rates as an intended stimulant to business expansion. The US Federal Reserve has heavily distorted all asset prices in North America to the upside and available yields on the downside by excessive monetary looseness and artificially low interest rates. The decline in yields in particular has hurt a large and growing segment of our population, the (now aging) ‘baby boomers’ who need increasing income from their savings. Their alternative is to either save more and thereby consume less or to consume their personal capital/savings in order to maintain current consumption levels. Income trusts offer an apparently promising third choice.

The Frenetic Hunt for Income

The income trust concept therefore came along as a godsend. With an aging population and steadily falling interest rates, there has been an increasingly frenetic search for investment income, both to support current consumption out of a finite amounts of savings, as well, for many others, the amassing of additional savings in RRSPs and so on. A few years ago, some bright soul stumbled over the royalty trust concept (whereby royalty income, notably in the oil, gas, and commodity resource sectors, can be bundled up and sold to others seeking income) and realized that the idea could be extended to other sources of corporate income as well. By directly paying out corporate cash flows in an income trust structure coupled with the paying out of the capital in the trust over time in a blended payment stream, taxes need not be paid (at source) and the resulting cash flow (“income”) stream is greatly enhanced to investors. But it has partially done so by converting corporate equity capital into income, as it is highly likely that most recipients of income trust payouts do not distinguish between the two aspects of income trust payouts, save, serendipitously, when they calculate their taxes payable in April.

The main motivation for conversions of companies into income trusts as far as the public is concerned is the ‘manufacture’ of higher levels of income in an era of otherwise very low yields. The model of the royalty trust, if there is a raison d’être for income trusts, is a sound and reasonable one. If one has royalties, why not indeed sell them off to those who want a stream of income? But converting operating businesses, and that includes most companies in the oil and gas industry, into income trusts does not stand up to scrutiny.

The first thing to say about such "conversions" is that they add nothing, absolutely nothing, to the economy's current and future income and revenue stream. These are purely financial transactions, occurring outside the economy and undertaken with the intent to extract gains from playing market valuations. In essence, this boils down to the financial plundering of corporations. The people working in these corporations are being converted from being entrepreneurs in the larger sense of the word into broom-wielding caretakers of slowly depleting assets. Yet by far and away the worst macroeconomic damage of income trusts occurs through their adverse effects on new capital investment. It is a highly reasonable assumption that firms that have been "converted" into income trusts will voluntarily curtail their alternative expansion through new capital investment. Some income trusts make an attempt to prolong the life of the trust through very modest new investment, to sustain the income stream for longer than would otherwise be the case, although to date those investments appear largely to be the product of acquiring additional income streams, not entrepreneurial activity which is hallmark of any growing economy. As equity is the hardest aspect of capital to acquire and build, systematically looting corporate treasuries of their equity to convert into income can do nothing but have a tremendously deleterious effect on long term capital accumulation and growth in Canada. In this way, the income trust conversion mania effectively diminishes the growth of the productive capital stock. Income trusts fuel current consumer spending, both through capital gains due to a rise in the stock price of a targeted company, and by boosting consumption due to the resulting increase in investment income. The net result, in the long run, is macro capital consumption and impoverishment.

To this, we would add the observation that in general, the income trusts pay out too much of their “free” cash flow. As the many of the levered buyouts (LBOs) discovered in the late 1980s, all of that cash flow is not “free”, but is required to support the business of the company/trust. Many of the LBOs ignominiously collapsed as they discovered all too late that the cash flow that they thought was available to meet the interest payments on the debt used for the leveraging was, in fact, needed to support other aspects of the business. It very much looks to us as though the income trusts are making the same error and we expect similar outcomes in a number of cases. Atlas Cold Storage is but one example among what we expect will be a parade.

You would think that this simple truth must be evident to anybody with a little common sense. But the Street writ large has succeeded in eliminating this potential bit of wisdom by postulating the convenient dogma invented by some academic nitwit that shares in a perfectly efficient market are always correctly priced. That would seem to support the call for short-term price maximization at the cost of longer term planning and investing. If converting to an income trust is “good” for the share price, then surely that it is “right” to do so, and current market thinking would very much appear to support this assertion.

But “business” is in the business of taking deliberate calculated risks, and protecting against unforeseen, or unforeseeable, risks by having sufficient balance sheet strength to survive future crises. The income trust structure inhibits even sensible risk-taking (where the anticipated payoff is some time in the future) and potentially creates solvency risk whenever an unforeseen negative development occurs. At best, the income trust structure maximizes transaction costs as trusts pay out their cash flow, and then must go back to the market to raise capital for new investment. If new investment is to be “accretive”, it must at least cover, on an immediate basis, the incremental distributable cash per unit already being paid on the previously outstanding units. Formerly, companies paid dividends equal to roughly 25% or so of income, unless they had a particularly good use for the funds, in which case they paid nothing. The same companies converted to an income trust pay out all and more of their income, even though the underlying business remains the same. Given that, it would not be surprising to find that some income trusts are currently paying out distributions to unitholders which will prove to be unsustainable, in terms of having sufficient resources to meet the ongoing needs of the business. Atlas Cold Storage is a case in point, and from our preliminary studies of income trusts, we expect that there are more of these ‘problem trusts’ on the way.

While the demand for income trusts among individual investors has been strong and steady, it is likely to be nothing compared to the rapacity of the pension funds should they, too, be permitted to partake at the income trust feast. In such a case, the mass destruction of corporate equity will be something to behold. One may well argue that as pension funds are savings vehicles, the income and repayment of capital received under income trust instruments will simply be a reallocation of the capital formation process. We would argue to the contrary, and especially depending on the type of pension plan involved. Many defined benefit plans are currently under water from an actuarial point of view and insofar as “secure high returns” on income trusts are used to bolster projected pension returns, the demand for income trusts will accelerate. The kinds of companies which would be attractive are those with highly defined streams of income such as oil and gas companies and utilities. The thought of having our utility structure weakened and gutted of capital over time is not one which is tempting, save to the scavengers who are looking more for quick gains and/or large conversion fees. The potential demand for energy in the future of an emerging China, India (and more of the current ‘third world’) plus the probable need for new investment as reserves dwindle does not suggest that gutting the energy sector of capital makes much long term sense either. In any case, pension funds are in the business of creating streams of income for retirees and our basic argument that income trusts represent a conversion of capital into income holds here as well. Ottawa should keep in mind that the prospect of income leads to consumption: the prospect of capital gains leads to wealth creation.

The Federal Government of Canada perceives that there is something wrong with income trusts and is attempting to call a halt to this general trend, citing the loss of tax revenues. The issue is not, however, one of losing some corporate income taxes should, for instance, Canadian pension funds be allowed to purchase income trusts on a broad scale. The issue is a far deeper one. Namely, to satisfy the potential demand for income trusts from pension funds (allowing the limited liability issue to be dealt with), the pressures on many dozens if not hundreds of larger companies with more or less regular and forecastable income flows to convert into income trusts as well will devastate capital formation in Canada for a long time to come. The longer term negative impact on employment and sustainable economic growth will be grossly malignant. On that basis alone, the Federal government should call a halt to the formation of all new income trusts until it can study, then hopefully quietly smothers the whole movement. If we add even further leakage due to payouts to foreign investors, which are beginning to dominate some income trust shareholders’ lists, the situation gets even worse. The Federal government is quite correct, in our view, in seeking to stop the pension funds from entering this area of investment. Our sole disagreement with the current stance in Ottawa is that we would argue that no holdings of income trusts should be permitted.

More recently, income trusts have been embraced by a host of Johnny-come-lately investors in Canadian companies who see them as an easy way to make some short-term hay by way of a quick gain in the stock price after a conversion announcement. Most of the complaints, for instance, being leveled at Manitoba Telecom in very recent days are coming from investors who were not invested in the stock during the years that this company has been painstakingly built into a balance sheet powerhouse. That is of no concern or interest to them. These investors are in there for a quick buck and never mind the damage they might do to the company’s future. Who cares anyway? It won’t be their problem ten years – or maybe even one year – hence.

From a macro-economic point of view, investing decisions are being distorted on the one hand by the short term exigencies of the US Fed to force the continuation of boom times by preventing the usual cyclical slowdown and adjustment phase from occurring, and on the other by the US federal government of George Bush to bring about its own reelection through massive tax rebates. We think this precisely describes what has been happening and continues to happen in the United States. The Greenspan Fed has discovered a new, amazingly easy and quick way to create higher consumer spending virtually from thin air – by way of so-called wealth creation through asset bubbles. It began with the stock market bubble, to be followed by bubbles in bonds, house prices and mortgage refinancing. As the effects of these policies perforce slop over into Canada and create an artificial demand for income and hence income trusts, available resources in this country are also being led in the wrong direction, as they were during the high tech mania, and here too, a definite and lasting adjustment is being postponed. In the longer term, this can only sow the seeds for new disturbances – and quite possibly new crises as well.

While not strictly a macro economic issue but rather one relating to investment risk, we would also observe parenthetically that while falling interest rates have spurred the growth of income trusts, rising interest rates will create a double whammy. The Distributable Cash of the Trusts will fall as interest expense rises, and the discount rate that is applied to their new (lower) distribution will also rise. While we believe that there is little opportunity for capital gain left in the income trusts at the present time, rates being about as low as one could reasonably (or even unreasonably) expect, and because no new internal growth in investment can occur because no cash flow is being retained to finance it, there is plenty of opportunities for capital loss. Interest rate increases will punish all trusts, but especially those with weak balance sheets. These kinds of risks are not being recognized in the market at the present time. Investors who think that they have invested for income and that “income” equates to “safety” in the income trusts, will then be quite surprised to discover that they actually hold equity vehicles, many with highly risky (read “lethal”) capital structures.

The motivation for investment in an income trust is substantially different from that in an ordinary corporation. Ordinarily, a company pays out a portion of its surplus earnings as dividend income that it does not require for its future expansion. Shareholder returns are therefore a combination of income and future growth. The motivation for an income trust is the payout of everything possible. It certainly does not behoove the income trust to do better and better in each and every year, nor plan for long term growth as presumably that would require investment and that in turn would detract from the income stream. The better income trusts do attempt to provide the barebones of additional investment so as to maintain the payout as long as possible, but clearly the line between a typical corporation with its risk-taking purpose and it shareholders has been cut. An income trust is an attempt to maximize immediate shareholder value (that is, price and income payout) in the short term, without regard to the long term sustainability of the enterprise. Perhaps, in the long run, as Keynes was once reported to have said, we are all dead anyway: however, this applies both to investors and those corporations which have been transformed into income trusts alike. That today we might get the highest price possible for a given company while destroying its future will prove to be but faint solace for our children.

Conclusions

The tremendous vulnerability of the U.S. economy due to its underlying heavy leveraging prohibits any defense of the dollar through monetary tightening. Instead, in the end, a plunging dollar is likely to pull the rug out from under the bond and the stock markets in that country. The U.S. economy's key problem is not foreign competition, but its own micro- and macroeconomic policies of boosting consumption at the expense of investment and its trade balance. Without intending to follow suit, in at least one regard, the widespread use of income trusts, Canada is inadvertently emulating the USA.

We feel a bit mean in attacking the last bastion of income production for all of those beleaguered investors who would probably feel even more put-upon if income trusts were to be killed. Unfortunately, this is a clear case of short term gain and a lot of long term pain. As such, it is not acceptable, especially on the scale that is being planned at the present time. Having snuffled around the corporate asset base and winnowed out the smaller players to serve as appetizers for the coming feast, the more aggressive investors and underwriters are now turning their attention to a much bigger prize, the major companies which are the bone and sinew of the Canadian economy.

To some, what Ottawa is trying to do looks a little like trying to roll back the clock or closing the barn door after the horse has bolted. However, the entire income trust issue has arisen so rapidly and its popularity has proven to be so overwhelming that Ottawa has not really had time for a truly objective assessment. The income trust movement is so overwhelming, in fact, that the income trust buyers and producers are now becoming far more ambitious in seeking out major new conversion targets. There is nothing wrong in the least with calling a halt to a bad idea, regardless of its popularity, and the current review by the Federal government should be extended to a complete moratorium.

If, as Ottawa has stated, the matter were simply a case of losing $1 billion or so in tax revenues, it would hardly matter provided that the tax loss tradeoff was one of faster capital formation and job creation in the future. But this is the exact opposite of what is happening. The resultant capital destruction will certainly lead to a loss of current taxes, but also it will result in a decline in entrepreneurial activity and future growth opportunities. On this basis alone, Ottawa should kill income trusts now. While there may still be some places where income trusts are appropriate, such as royalty trusts, the onus of proof as to their future economic efficacy should shift to the sponsors and underwriters, and the standards of proof should be very high indeed.