From the September 2004 issue of Investment Advisor • Subscribe!

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One Canadian incursion has already happened: income-deposit securities

Two of Canada's major banks are confident the newest asset class in Canada will be all the rage in the U.S. Both Canadian Imperial Bank of Commerce and Royal Bank of Canada are front and center of the burgeoning "income-deposit securities" or IDS market, the Americanized version of income trusts.

IDS units are investing vehicles that combine a high-yield bond and a common share and can be separated into individual pieces after the initial offering. They typically yield between 9% and 11% and distribute the free cash flow of a stable, predictable, modest-growth business to shareholders. A typical IDS candidate is a company that has annual revenues of at least $150 million and cash flow of $25 million.

So far only one IDS has been offered in the U.S.--CIBC raised $277 million when it brought to market Volume Services America Holdings, a stadium concessions company, in late 2003--but CIBC spokesman Stephen Forbes says there are about 21 potential deals in the pipeline looking to raise around $12 billion. In addition to CIBC, other potential underwriters for those deals are Lehman Brothers, Goldman Sachs, JP Morgan, Bank of America, Citigroup, CSFB, and Royal Bank. Forbes says the income trust market is worth $55 billion U.S. in Canada. They have become so popular that they are mentioned in that the same breath alongside stocks, bonds, and mutual funds.

A recent report from BMO Nesbitt Burns analyst Ian de Verteuil said that CIBC and RBC, which are involved in most of the offerings, would earn about $155 million and $56 million, respectively, in underwriting fees once the pipeline is opened up.

He speculated that $12 billion worth of IDSs would be offered each year and that U.S. players will embrace the segment if it takes off as expected. Even so, he said Canadian banks will likely retain about 10% of the IDS market.

Forbes says after seeing the popularity of income trusts explode in Canada from 2000 to 2002, the bank began examining ways to bring them to the U.S. A hybrid product was created in 2003 to meet the different regulatory environment south of the 49th parallel.

Forbes argues that the most appealing feature of an IDS may be that it provides a predictable yield. "You don't have the upside or downside of an equity product," he says. In the new era of disclosure and corporate governance, he says that the transparency of a company paying out a dividend on a quarterly basis is also attractive to investors.

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