Download Income Trusts: Is There a Bubble?

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FISCAL DESIGNING & YOU!
Ryan Sharp and Wing Hua
Income Trusts: Is There a Bubble?
I
ncome Trusts have been receiving a
great deal of press in recent months.
Some analysts say they are forming a
bubble that is about to burst. That may
not be the case. When making any
investment decision, however, it is always
necessary to understand the risks. To help
you make informed decisions, we offer an
explanation of income trusts, their tax
treatment, and the risks involved.
Income trusts continue to be a
growing sector of the Canadian market.
The float capitalization has increased
from $26 billion to $55 billion since
December 31, 2000. They now represent
a market capitalization equivalent to
approximately 7 percent of the
S&P/TSX Composite Index. This figure
should rise significantly as a majority of
new IPOs continue to be income trusts.
What are income trusts?
Income trusts are equity instruments that
generally provide unit holders with
frequent and relatively stable
distributions of operating cash flows
from their underlying business. The
underlying assets of an income trust are
normally mature businesses with low-tomoderate growth with a predictable
stream of free cash flow.
With average yields of approximately
12 percent, they provide an attractive
income source for investors in this low
interest-yield environment. Although
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they are high-yielding financial securities,
a comparison with fixed income
securities is not appropriate. They should
still be considered as equities when
examining risk tolerances.
Small investors gain the
benefits of expert
management and broad
diversification.
There are generally four types of income
trusts.
1. Oil and gas royalty trusts are an
income-oriented, high-yielding
equity investment that pay out a
monthly distribution based on the
net revenues derived from producing
oil and gas fields.
2. Real Estate Investment Trusts
(REITs) invest in real estate assets
and pay the income on the
properties to unit holders. They are
an alternative to directly investing in
real estate.
3. Power income trusts consist of
privately owned power generating
facilities characterized by long-term
fuel supply arrangements and sales
contracts.
4. Business trusts are mature
businesses that are either dominant
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in the market or heavily regulated
with steady cash flows and low
growth prospects going forward.
Tax advantaged feature
An important distinguishing aspect of
income trusts is their avoidance of
income taxes on the underlying business
income. The capital structure effectively
shelters the business income from most
forms of taxation and allows its earnings
and cash flow to be transferred to the
unit holder.
Outside of a registered account, this
distribution is taxed as regular investment
income. Many income trusts, however,
distribute their earnings tax deferred as
return of capital. Essentially the cost base
of purchasing the units is reduced by the
return of capital amount. When the units
are sold, the difference between the
selling price and the adjusted cost base is
taxed as capital gains.
What are the risks?
It is important to discuss the risks of any
asset class when determining if it is suitable
for you. One of the greatest risks to
investing in income trusts is the reliability
of cash distributions affected by quality
and sustainability of earnings. Dominion
Bond Rating Service rates income trusts
on their ability to maintain those
distributions. They range from SR1 to
SR7, with SR1 being the highest rating.
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The general level of interest rates is
also a major factor that influences the
unit prices of most income trusts. As
interest rates increase, the price of income
trust units will fall, as occurs with other
fixed income investments. Current
interest rates, however, have stabilized as
growth forecasts have been adjusted
downward. Although investors in income
trusts should watch interest rates, it is not
likely to be an immediate risk.
One of the major questions that has
surrounded income trusts is their
unlimited liability. Ontario introduced Bill
41, which essentially gives unit holders the
same unlimited liability as regular
shareholders. Unfortunately, parliament
adjourned for the summer of 2003 before
the legislation could be passed.
So is there a bubble? There are risks
to investing in income trusts but they
can be mitigated as long as investors
make informed decisions. Don’t invest
just on the basis of yield. The quality of
the income trust and its ability to sustain
distributions need to be closely examined
prior to making any investment
decisions.
Alternative Investment Idea
Instead of investing in individual income
trusts, numerous income trust index
funds and mutual funds are available.
They reduce the risk by investing in a
large number of individual income
trusts. The distributions are still passed
on to the unit holders and yields are
currently in the 6 to 12 percent range. ▲
Ryan Sharp, MBA, is an Investment
Executive with ScotiaMcLeod, providing
wealth management and financial
planning advice for his clients.
Voice: 604 661-1486
[email protected]
www.advisors.scotiamcleod.com/rsharp
Wing Hua, BA, CIM, is an Investment
Executive with ScotiaMcLeod,
specializing in investment and
retirement planning.
Voice: 604 661-7471
[email protected]
www.advisors.scotiamcleod.com/whua
Volume 12 Number 3 October 2003
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