The downtrodden and unpopular can provide investing opportunity! There are some enticing indicators of substantial reward too. But first ...
What are Income Trusts?
- a form of equity security - distributions are not guaranteed like debt, hence riskier
- frequent (often monthly) and substantial cash distributions - used by investors for regular income
- traded on a stock exchange but are called units not shares and are distinguishable by the addition of the suffix UN to the symbol, e.g. BA.UN.
- unlike investment trusts and mutual funds which own baskets of assets or shares in many companies, income trusts are confined to a single company.
- wide variety of business types and thus differing stability or risk
Why the attraction now?
HIGH YIELD! At current low prices, the annual cash payout is well over 10% for many income trusts. See this handy extract table from Investcom.com:
That's not the end of the story, however, since cash distributions can and might be suspended or reduced, unwelcome though that might be.
What are the risks to distributions?
- Payouts too high to sustain the business' underlying needs to service debt and make capital expenditure re-investments. Income trusts may pay out 50-90% of profits on an on-going basis; when it is over 100%, watch out, that will deplete the business if more than temporary or short-term.
- Leverage - if the underlying business has a lot of debt relative to revenue, downturns can be fatal.
- Rising interest rates - can damage two ways: a) the underlying business runs into debt servicing problems and b) the fund units lose value since the distribution is less competitive with other sources of regular income like bonds; though the distribution may not decline, its value is less.
- Falling commodity prices - for funds based on resource stocks, whether oil, gas, minerals or other commodities, the effect on unit prices can be rapid and dramatic as sustained drops will reduce the ability to pay distributions
- 2011 and Corporate Tax - expect a one-time hit to distributions of most Income Trusts when the rule kicks in
- sustainability of distributions - use DBRS Issuer Ratings and Standard & Poors who rate many (though not all) funds for stability of payouts; think how much the distribution could drop before the return would be too harmful; some businesses grow their distributions, they are not just stagnant "cash cows" though most of the expected return will be distributions, not gains on the unit price; sustainability risk is generally ranked like this:
- Lowest risk - Power Generation
- Low - Pipeline, Telephone
- Medium - Real Estate: office, commercial, mortgage, apartment, hotel
- High - Business - retailing, restaurants, trucking, cold storage etc
- Highest - Oil & Gas Royalty, Commodity
- tax character of income distributed - this varies with each fund - some provide mostly dividends, others primarily interest / other income, others a mix of capital gains with dividends; this affects where the fund goes best, in a registered or taxable account
- GlobeInvestor Stock filter - use the "Security" drop down menu to select Income Trusts (units); discount brokers probably have a similar feature - I know BMO Investorline offers its clients the Gold version of GlobeInvestor
- Investcom.com - doesn't list them all, but groups them by industry and shows their yield
- PricewaterhouseCoopers Planning for 2011 and Beyond covers business, strategic, tax issues as of May 2008
- TMX Money downloadable listing of all TSX-traded Trusts with size and business sector
- CanadianMoneySense Ranking of Top 100 Income Trusts - June 2008 data with online sorting
- iShares Income Trust Sector Fund (XTR) and REIT Sector Index Fund (XRE)
- Closed-end Funds at GlobeInvestor - some of them hold income trusts and are themselves structured as trusts; check the ".UN" in symbols then drill down to verify the contents
Note that this post is not meant to be an investment recommendation. It is merely to illustrate current conditions.