DBRS Downgrades Energy Split Corporation’s Class B Preferred Shares to Pfd-3 (high)

DBRS has today downgraded the Class B, Preferred Shares (the Preferred Shares) issued by Energy Split Corporation (the Corporation) from Pfd-2 (low) to Pfd-3 (high) with a Stable trend and has removed the Preferred Shares from Under Review with Developing Implications where the rating was placed on November 8, 2006.

The net asset value (NAV) of the Corporation decreased significantly shortly after its reorganization. The quick decline can be attributed to the Canadian government’s October 31, 2006, announcement relating to the change in taxation on income trusts and to the sensitivity of the Royalty Trust Portfolio, consisting of oil and gas income trusts, relative to the price of oil. Downside protection decreased from 54% at reorganization to 42% on November 2, 2006. Since then, the downside protection fluctuated in a band from 35% to 45% before falling to 34% on August 30, 2007, the low point since reorganization.

The investors of the Preferred Shares and Capital Shares gain exposure to the Royalty Trust Portfolio through a forward purchase and sale agreement (the Forward Agreement) with the Bank of Nova Scotia (the Counterparty). The Counterparty will pay the Corporation the economic return provided by the Royalty Trust Portfolio, which will be held by an underlying fund (the Royalty Fund). In return, a portfolio of common shares of Canadian public companies acquired from proceeds of the initial offering in 2003 was pledged to the Counterparty. The Forward Agreement is structured to provide tax-efficient distributions to the Corporation’s shareholders based on the performance of the Royalty Trust Portfolio.

The holders of the Preferred Shares receive a fixed preferred tax-efficient quarterly distribution equal to an annual yield of 4.5%. The holders of the Capital Shares are entitled to leveraged tax-efficient distributions that are in excess of distributions paid to the Preferred Shares and all operating expenses of the Corporation.

The Pfd-3 (high) rating of the Preferred Shares is based on the downside protection available to the Preferred Shares, the dividend coverage ratio for the Preferred Shares being greater than one, and the combination of oil and gas exposure in the underlying income funds, which provides some diversification and stability for a portfolio concentrated in a commodity-based sector.

The main constraints to the rating are the following:

(1) Income trusts typically distribute a mix of income and capital, which can grind down the NAV of the portfolio over time.

(2) The high correlation of the Royalty Trust Portfolio to the price of oil and natural gas.

(3) Regulatory risk as it relates to the federal government’s proposed taxation policy on income trusts.

The redemption date for both classes of shares will be September 16, 2011.

Note:
All figures are in Canadian dollars unless otherwise noted.