03 November 2006

Banks May Suffer from Trust Market Demise

The Toronto Star, Tara Perkins, 3 November 2006

The surprise death of income trusts as Canada knows them could chop earnings at Canada's big banks by 2 to 4.5 per cent in a worst-case scenario and will materially damage growth of the mutual fund industry, analysts say.

"We believe the government changes to the income trust structure will have a material negative impact to the growth rate of the Canadian mutual fund industry," CIBC World Markets analyst Stephen Boland wrote to clients yesterday.

He now expects the mutual fund industry to grow by 5 per cent in 2007, down from his previous assumption of 12 per cent. Instead of 4 per cent growth in net sales, he expects 1 per cent net redemptions.

"We believe that the two key drivers of growth in the Canadian (mutual fund) industry have been ongoing strength in commodities and the continued popularity of the income trust sector," Boland wrote.

"Following the technology bubble in the early 2000s, investors lost confidence in the ability of the (mutual fund) industry to protect capital. The birth of income trust products gave some comfort to those investors that were not searching for gains but instead searching for yield and security," he wrote.

"Based on the market correction, this may again shake investor confidence in the industry and create a steady redemption pattern."

He expects the implications for independent fund companies — such as CI Financial, AGF Management and IGM Financial — are negative

In a separate note, CIBC banking analyst Darko Mihelic said the impact of the income trust changes on Canadian bank mutual fund arms will be slightly more moderate, but he nevertheless concurs "that mutual fund growth is likely to slow and thereby hurt our forward wealth management estimates."

Wealth management makes up, on average, 14 per cent of earnings at the banks.

But, while the big banks' wealth management divisions might feel a little pain, their investment banking arms could really suffer.

The drastic changes to income trust tax rules will hit the banks' underwriting commissions and asset management fees, Mihelic said.

In the past 12 months, about 30 per cent of the banks' earnings came from their capital markets, or investment banking, business. And income trusts have represented about 35 per cent of all equity issuance in Canada, Mihelic wrote.

Overall, "we estimate earnings are at risk in a range of between 2 per cent to 4.5 per cent for all of the Canadian banks as a worst case scenario," he wrote.

Mihelic did not alter his target prices for the bank stocks, largely because the stocks may be an area of refuge for investors who are hungry for yield in the wake of the government's announcement.

Banks currently have a 3.2 per cent dividend yield.
Bloomberg, Doug Alexander and Sean B. Pasternak, 2 November 2006

RBC Capital Markets, CIBC World Markets and other investment banks and law firms may suffer from the Canadian government's move to shut down income trusts, which accounted for a third of new equity sales this year.

Within hours of the government's announcement Oct. 31 that it will tax trusts for the first time, firms such as Algonquin Power Income Fund postponed or reviewed plans to sell new trust units, potentially depriving the banks of adviser fees.

"The banks have been milking the trust mania for years," said Todd Johnson, who helps manage about $640 million at Cardinal Capital Management Inc. in Winnipeg, Manitoba, including bank shares.

The government's move to stem the flood of conversions and initial public offerings of income trusts threatens a growing source of fees for investment banks in Canada. The Toronto-based banks have benefited from merger advice, trading, and sales of debt and equity by the trusts. Lenders such as Bank of Montreal and Royal Bank of Canada have set up research teams of five to 10 analysts just to cover the C$180 billion ($159 billion) sector.

Trusts accounted for about a third of the $17.4 billion in new equity sold this year, according to data compiled by Bloomberg. RBC and CIBC rank first and second for income trust sales, which have included IPOs by Teranet Inc., and units of BCE Inc. and ACE Aviation Holdings Inc.

Banks including BMO Capital Markets, Goldman, Sachs & Co. and RBC Capital Markets received combined fees of C$51 million from advising BCE on spinning out Bell Aliant into a rural telephone lines trust this year. And trust sales contributed to a 14 percent gain in overall equity sales this year from the same period in 2005, according to Bloomberg data.

Some trusts have been sources of banking fees for years. Yellow Pages Income Fund, owner of the country's largest phone directories business, has sold shares six times since its initial public offering in 2003, raising more than C$5 billion and paying fees to banks including Scotia Capital and CIBC.

Canadian Imperial Bank of Commerce, the country's fifth- biggest bank, may be hardest hit by the tax changes. CIBC may have a 4.5 percent decline in 2007 earnings in a "worst-case scenario," CIBC World Markets analyst Darko Mihelic said today in a research note. Royal Bank's earnings could fall by 3.4 percent, compared with 3.2 percent at Bank of Montreal. The banks may also lose asset management business from the demise of trusts, he said.

"Depending on the bank, you've got from 20 to 35 percent of the earnings coming from the investment bank," Mihelic said in an interview. "So there will be an impact -- it's difficult to pin down."

CIBC World Markets spokeswoman Susan McDougall didn't return calls seeking comment. RBC Capital Markets spokeswoman Jackie Braden declined to comment.

Fees for bankers and lawyers selling trusts or converting companies to the tax-exempt securities may fall because Finance Minister Jim Flaherty said new trusts will be taxed in the 2007 tax year. Existing trusts would lose their tax benefits starting in 2011, removing any incentive for firms to convert to a trust.

Already, companies such as BCE and Telus Corp., the two- biggest phone companies in Canada, are reviewing plans announced over the past six weeks to adopt the trust structure. BMO Capital Markets, Goldman, Sachs & Co., and RBC Capital Markets, a unit of Royal Bank, advised BCE on the conversion. TD Securities worked with Vancouver-based Telus.

Extendicare Inc., which operates nursing homes in North America and the U.K., said it will delay plans to convert to a real estate investment trust. Dundee Wealth Management Inc. said it's also "re-evaluating" plans to sell a minority stake in its Goodman & Co. mutual fund arm as an income trust.

"It definitely eliminates conversions, it eliminates trusts IPOs," and some trusts will be acquired, said Scotia Capital income trust analyst Navdeep Malik, one of eight analysts who covers trusts and REITs for the bank. "After 2011 you don't need the trust structure and that is part of the government's objective."

The income trusts have also contributed to trading fees for Canada's biggest banks and TSX Group Inc., owner of the Toronto Stock Exchange. The 255 trusts on the Toronto Stock Exchange had a combined value of C$200 billion at the end of September, or about 11 percent of the exchange's market value.

Still, bank shares have risen the past two days as investors unload trusts and shift into dividend-paying stocks. Royal Bank, the biggest lender, rose C$1.20, or 2.4 percent to C$51.60 at 4:10 p.m. on the Toronto Stock Exchange after touching a record high of C$51.96 earlier today.

Johnson said investment banking fees are always volatile, and bankers will probably shift their focus to common share IPOs and mergers.

"They should be able to earn their money elsewhere," he said. "They've got so many things going on."

Banks and law firms may also get fees as trusts convert back to a common share structure or get acquired, either by trusts, corporations or private equity firms.

Law firms such as Torys LLP, which collect fees from trust IPOs and other equity sales, may also see a shift to mergers and acquisitions.

"The IPO market has been close to dead for the last year anyway and the Canadian law firms have been doing other types of income trust activity," such as mergers and conversions, said Philip Brown, co-head of mergers and acquisitions at Torys LLP in Toronto.