Friday 30 January 2009

Income Trusts: a Neglected Opportunity?

Income trust investors have had a bad time in recent years. First came the 17% downward price hit from the federal government's announcement Oct.31, 2006 that henceforth such trusts, except for qualifying REITs, would be taxed like corporations. Then came the credit crunch market collapse of 2008, which has seen their price fall significantly more than the rest of the market - in the graph below compare the TSX Income Trust Index (red line) and an ETF (green line, symbol XTR) of income trusts to the TSX Composite (blue line).

The downtrodden and unpopular can provide investing opportunity! There are some enticing indicators of substantial reward too. But first ...

What are Income Trusts?
Key Features:
  • 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
Shakespeare's Primer on Trusts and the Wikipedia article on Income Trusts provide more detail.

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?
  1. 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.
  2. Leverage - if the underlying business has a lot of debt relative to revenue, downturns can be fatal.
  3. 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.
  4. 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
  5. 2011 and Corporate Tax - expect a one-time hit to distributions of most Income Trusts when the rule kicks in
What to consider in assessing Income Trusts
  • 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:
  1. Lowest risk - Power Generation
  2. Low - Pipeline, Telephone
  3. Medium - Real Estate: office, commercial, mortgage, apartment, hotel
  4. High - Business - retailing, restaurants, trucking, cold storage etc
  5. 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
Where to find Income Trusts
Disclaimer
Note that this post is not meant to be an investment recommendation. It is merely to illustrate current conditions.

3 comments:

ever changing said...

Hello,
I just found your blog and must admit it is one of the best I have seen on Finances! I am just a beginner in Finances and stocks and etc etc...
I'll be in touch with you with some questions, hope you'll be able to explain them to me in baby-language... :-)
Thanks

auto loan rates said...

Income trusts are the equity investments which secuire your fixed income. The income trusts announced in the october 31 2006 which is very beneficale for the persones who earn fixed income.Auto Loan Rates
,entertainment source,clothe shop

toronto home renovations said...

Don’t think and chouse it, because its realty very beneficial for you. We will have to wait and see what happens. I am sure that its great opportunity for us!!!