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Scriv Fall 03 10/1/03 8:21 PM Page 24 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 24 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 The Scrivener 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. Volume 12 Number 3 October 2003 Scriv Fall 03 10/1/03 8:21 PM Page 25 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 The Scrivener 25