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Fund Talk
Are Income Trusts Fixed
Income Or Equity?
Rachel Michaud
I
ncome trusts are currently the fastest growing product in the Canadian investment industry. Low interest rates and, until recently, weak equity returns have
greatly contributed to the popularity of income trusts.
The Canadian income trust market has grown from 26 billion dollars in 2000 to approximately 60 billion dollars in
2003. The number of income trusts listed on the Toronto
Stock Exchange has doubled in the past three years.
With an average yield above 9%, investors have been
attracted to income trusts by their high distributions. Additionally, income trust investments provide tax-saving benefits, which increase the value of a firm converting to an
income trust. Some companies have seen their stock price
jump as much as 30% on the news of their trust conversion. Income trusts are mainly created by companies and
private firms to raise capital. Good candidates for trust conversion are stable businesses, relatively mature, and with
predictable cash flows.
The income trust structure was developed to facilitate
distributions to investors on a tax-efficient basis. Traditionally, resource and real estate firms dominated the income
trust market. As the income trust market is growing, companies in other sectors are joining the resource and real estate companies and converting into trusts. This structure is
well suited for maturing industries with a low growth rate.
Despite the popularity of income trusts, few investors really understand the risks of this type of investment. Many
investors even describe income trusts as fixed income like
bonds but in reality income trusts have much more in common with equities. In this article, I will examine the risks
involved with investing in income trusts and discuss how
investors can minimize those risks.
Income trusts are similar to bonds because they pay a
fixed amount at regular intervals. Just like bonds, the higher
the income trust yield, the higher the risk. Both bonds and
income trusts are sensitive to interest rate movements but
the similarities end there. The risk profile of bonds and
income trusts is very different. Income trust distributions
are not guaranteed and can fluctuate.
Distributions are paid from earnings but can include a
portion of the initial capital (principal or investment
amount) invested. The return of the initial capital decreases
the cost base of the income trust. Unit holders do not pay
any tax on the portion of the yield representing the return
of capital. The capital gain is deferred until the units are
sold and is calculated using the cost base adjusted downward by the amount of capital returned. When you are getting part of your initial investment back, the actual return
(percentage) from the income trust will be lower than the
income trust yield. Higher yield income trusts do not mean
that they have the best returns because a higher payout may
mean that the income trust is making some or most of its
distributions from return of capital. Some investors make
the mistake of thinking that the yield from an income trust
is the actual return. If the income trust yield is greater than
its actual return, distributions will have to be decreased in
the future because the initial capital is being eroded by the
amount of its return. Income trust distributions can also
fluctuate with business conditions and even disappear if
the company is not earning enough money or if it has returned all the initial capital to investors.
The potential for fluctuations in payout ratios makes
income trusts ill suited for Registered Retirement Income
Funds (RRIFs). Income trusts are under pressure to maintain distributions to unit holders but they could decrease
them if the underlying business does not have enough
money to pay them. An unexpected cut in distributions
will have a negative impact on the trust unit price. The
uncertainty regarding distributions from income trusts
makes them much more risky than bonds. Therefore, income trusts are not a suitable replacement for bonds.
Stocks and income trusts are similar in the sense that
their return depends primarily on their earnings from businesses. Income trusts should be evaluated like individual
stocks for their future earnings. Sector and company specific characteristics must be analyzed to determine the risk
of a particular income trust. Two main differences exist between income trusts and regular equities.
© Canadian MoneySaver • PO Box 370, Bath ON K0H 1G0 • 613-352-7448 • www.canadianmoneysaver.ca
March 2004
First, a public company must pay taxes from its income,
whereas income trusts pay no tax. This allows investors to
avoid double taxation inherent in the Canadian tax system. Second, income trusts tend to be less risky than standard equities because companies that convert to the income
trust structure are usually in maturing industries. These
firms have high and predictable cash flows. They want to
distribute as much of their cash flow as possible while minimizing taxes.
High payouts are beneficial for investors. Many studies
have shown the advantages of high payout ratios because
they encourage management to make careful spending decisions and to operate the firm in a manner that maximizes
the income streams to investors. For companies that do not
need capital to finance growth, converting to an income
trust structure is a tax-efficient way to distribute earnings
to investors. Income trusts are, therefore, usually less risky
than standard equities but they also have limited growth
potential.
The risk of income trusts fall between that of bonds and
regular equities but that will also depend on the specific
characteristics of the income trust. The first factor to look
at in order to evaluate risk is to consider the type of income
trust. There are four main categories of income trusts.
Resource trusts and real estate income trusts (REITs)
used to dominate the income trust market. However, companies in other sectors have converted into income trusts.
Utility and business trusts are widely available now.
Resource trusts represents 26% of the income trust market in Canada. The resource sector is made up of oil and
gas companies. This sector has performed very well in the
past few years. The global economic recovery has pushed
commodity prices higher, especially oil prices. This sector
is vulnerable to decreases in the price of crude oil. However, according to the S&P income trust rating system, oil
and gas trusts have the highest variability and lowest
sustainability of distributions, compared with other trusts.
Resource trusts are vulnerable to decreases in the price of
crude oil. In addition, high capital costs threaten distribution payments and the sector faces rapid depletion of its
resource. Some of the large resource trusts include
Pengrowth Energy Trust, Enerplus Resource Fund, ARC
Energy Trust and Primewest Energy Trust.
REITs constitute more than 20% of the income trust
market. Like resource trusts, they have been performing
very well since 2002. This sector is sensitive to interest rate
movements. Low interest rates have greatly contributed to
the excellent performance of REITs but their performance
also depends on the state of the economy. Hotels’ profits
are linked to business travel while earnings from apartment
complexes and property management companies depend
largely on vacancy rates. H&R Real Estate Investment Trust
is becoming one of the biggest REITs. H&R has large cli-
ents like Wal-Mart and Home Depot.
Utility trusts have also grown in importance. They represent 14% of the income trust market. Utility trusts are
made up of power generation, pipeline and telecommunication firms. Power generating and pipeline trusts are particularly sensitive to fluctuations in interest rates. Consumer
demand will also affect the earnings of utility firms.
TransAlta Power L.P., Pembina Pipeline Income Fund and
Energy Savings Income Fund are a few examples of utility
trusts.
Business trusts are now dominating the income trust
market, making up about 40% of the market. Just like utility trusts, the risk of a business trust depends on the industry it operates in and specific characteristics of the firm.
Business trusts include all kinds of industries like fast food
chains, luxury hotels, mattress manufacturers and fertilizer
producers. The Yellow Pages Income Fund is considered to
be the largest issuance of income trust units ever made in
Canada with a 1-billion dollar initial public offering in
2003.
There are several types of risks to consider when investing in income trusts including interest rate, sector and company specific risks. The quality and sustainability of earnings is an excellent indicator of risk. One concern is that
the income trust may have to cut distributions if they do
not have enough cash flow to pay them. Dominion Bond
Rating Service (www. dbrs.com) rates income trusts on their
ability to maintain distributions. Two other risks are specific to income trusts. Although unlikely, the tax loophole
could one day be eliminated. Additionally, unlike investors
in bonds and equities, income trust unit holders have unlimited liability. Unit holders may be liable beyond the value
of their initial investment. Unlimited liability increases the
risk of income trusts. However, the liability issue and other
concerns may be resolved in the near future by the government.
Buying a single income trust is like owning only one
stock as you lack proper diversification and expose yourself
to the risk of making a bad choice. Income trusts are relatively new investment products. Like any new product, there
is a learning curve. Since the income trust market is evolving rapidly and income trusts have specific risks attached
to them, it may be more efficient to have a professional
manager select individual income trusts for you.
Unless you are familiar with income trusts and are able
to diversify your portfolio within this asset class yourself,
income trust mutual funds may be the best solution to invest in this new asset class while minimizing risk. Income
trust mutual funds allow investors to diversify within this
new asset class and to take advantage of the expertise of a
professional manager specializing in income trusts. As with
all mutual funds, income trust mutual funds can greatly
differ from fund to fund. With four categories of income
© Canadian MoneySaver • PO Box 370, Bath ON K0H 1G0 • 613-352-7448 • www.canadianmoneysaver.ca
March 2004
trusts to choose from, fund managers can decide to overweight or underweight some sectors. Before investing in an
income trust mutual fund, it is important to consider the
sector allocation of the fund as well as the manager’s ability
to select high quality income trusts.
Some of the largest diversified income trust funds include CI Signature High Income, Dynamic Focus Plus Income Trust, GGOF Monthly Income, Renaissance Canadian Income Trust, Talvest Millenium High Income, Bissett
Income, and Elliott & Page Monthly High Income.
Income trusts are very different from bonds and equities. Returns from income trusts have their own patterns
and are affected by several factors. Income trusts offer several benefits to its unit holders including tax savings and a
new asset class to diversify a portfolio. The unlimited liability issue will be resolved soon, which will attract many
institutional investors who have shied away from income
trusts because of this issue.
Increase in demand for income trusts could extend the
great performance of income trusts into 2004. However,
bear in mind that like any asset class, income trusts have
their ups and downs. Higher interest rates and a renewed
enthusiasm for equities could negatively impact their performance. Income trusts tend to perform better in down
markets. Furthermore, income trusts are not a good substitute for bonds. Efficient diversification of your portfolio in
and within each asset class is important to reduce portfolio
risk.
Rachel Michaud, MBA, CFA, SRM Consultants,
Mississauga, ON (905) 273-7435 [email protected]
A Selection of Income Trusts Ranked by Yield
RESOURCE INCOME TRUSTS
Name
Paramount Energy Trust
APF Energy Trust
NAV Energy Trust
Harvest Energy Trust
Pengrowth Energy Trust Units
ARC Energy Trust Units
Enerplus Resources Fund
Symbol
PMT.UN
AY.UN
NVG.UN
HTE.UN
PGF.UN
AET.UN
ERF.UN
Yield
22.08%
18.01%
18.00%
17.96%
13.96%
12.10%
11.08%
BUSINESS INCOME TRUSTS
Name
Westshore Terminals Income Fund
Custom Direct Income Fund
Prime Restaurants Royalty Income Fund
Sun Gro Horticulture Income Fund
Rainmaker Income Fund
Hot House Growers Income Fund
Yellow Pages Income Fund
Symbol
WTE.UN
CDI.UN
EAT.UN
GRO.UN
RNK.UN
VEG.UN
YLO.UN
Yield
14.29%
11.96%
11.52%
11.37%
11.35%
11.10%
7.32%
REAL ESTATE INCOME TRUSTS
Name
Lanesborough Real Estate Investment Trust
TGS North American Real Estate Investment Trust
InnVest Real Estate Investment Trust
Morguard REIT
Dundee REIT
H&R Real Estate Investment Trust
RioCan Real Estate Investment Trust
Symbol
LRT.UN
NAR.UN
INN.UN
MRT.UN
D.UN
HR.UN
REI.UN
Yield
10.87%
9.92%
9.66%
9.20%
8.84%
7.07%
7.05%
UTILITY INCOME TRUSTS
Name
Heating Oil Partners Income Fund
Amtelecom Income Fund
Clean Power Income Fund
KeySpan Facilities Income Fund
Boralex Power Income Fund
Pembina Pipeline Income Fund
TransAlta Power L.P.
Symbol
HIF.UN
AMT.UN
CLE.UN
KEY.UN
BPT.UN
PIF.UN
TPW.UN
Yield
9.76%
9.63%
9.42%
8.65%
8.45%
7.90%
7.82%
Source: http://www.investcom.com/incometrust.htm
© Canadian MoneySaver • PO Box 370, Bath ON K0H 1G0 • 613-352-7448 • www.canadianmoneysaver.ca
March 2004