Tuesday, 30 March 2010

Income Trusts - Amazing Returns During a Disappearing Act

A little over a year ago, this blog asked whether Income Trusts, with their exceptionally high yield at the time, presented the investor with a Neglected Opportunity? It turns out the answer was an emphatic Yes!

While the overall TSX Composite total return (which includes both dividends and the market price rise) in the year since last March 16th, in the rebound from the 2008 market crash has been an outstanding 47.6%, the Income Trust sector index has gained an even more amazing total return of 66%!

Income trusts had on average cut their high distributions drastically during late 2008 in response to the market crash and lowered petroleum prices (many income trusts are energy companies). However, many did manage to maintain their distributions and even start increasing them during 2009 as seen in the chart below of the price and cash distributions of the iShares Canada Income Trust Sector Index ETF (symbol XTR) that tracks the overall index. Nevertheless, yields are lower but still very attractive today at around 8.8% vs over 10% a year ago - because the market price of income trust units has risen strongly. (For details of yields of individual trusts, see this listing on Investcom.)

What About the Future?
It's perhaps interesting to look back and think "what if" but the future is what really counts so what factors will influence the future prospects for income trusts? Here are some probable and potential consequences:

Income trusts will continue to disappear - the October 2006 federal government tax policy decision to tax all but qualifying REITs as corporations eliminated the advantage of the income trust structure and the slow demise of the income trust has been proceeding before the new tax rule comes into effect in 2011 (see TaxTips.ca description of taxation an investor faces and will face as an income trust investor). From a peak of about 247 trusts in 2006, there are now only 163 left. So far, a minority of the departed trusts - about a third of them - converted to corporations. The rest have been bought out and taken over by tax-advantaged pension funds or foreign companies or investment funds (see sample names on The Marshall Plan). It is likely the mix will change more to conversion to corporations rather than takeovers since the majority of remaining trusts are in the Business sector (see TSX website for breakdown and complete list). The options and the consequences for investors break down as follows.

  1. Remain as Income Trust - most REITs are expected to remain as income trusts, and a few non-REITs may do so too if they still have tax losses that permit tax-free distributions, according to Blakes law firm which specialises in this sector. High distributions in this group may not decline at all or may even increase if economic conditions remain in the upswing.
  2. Conversion to Corporation - cash distributions will get cut after conversion due to the extra tax to pay by the corporation but for the taxable payer/account, the net effect after tax for the investor can be a wash since the investor now receives a dividend tax credit (see PriceWaterhouseCooper report mentioned in the original posting). Someone holding such an income trust in a RRSP or other registered account will see a real decline in income - 30% is the amount of the new tax rate and is a reasonable starting guess for the reduction. After conversion, the usual business assessment techniques will need to be applied to judge the on-going viability of the business, the stock and the dividend.
  3. Buyout - there may be a healthy premium to market value when a takeover occurs and the income trust owner may receive a good capital gain (e.g. the 300% premium for PrimeWest Energy Trust in 2007 paid by the Abu Dhabi national oil company or the 47% premium for Harvest Energy Trust in October 2009 by the Korea National Oil Corporation. That kind of result is not assured in every case and no doubt speculators are looking closely at remaining trusts to spot likely candidates, which tends to bid up prices, so an investor is not assured of success playing the takeover premium guessing game. If there is still a buyout premium value amongst income trusts overall, one way to play the game is to invest in a fund with many holdings, such as XTR or a Closed-End Fund with income trust contents amongst the CEFs listed at GlobeInvestor.
It is also not easy to decide which outcome, status quo, conversion or takeover, will apply. Checking out each trust's website for management statements in annual reports or press releases may give the answer as to which way the trust will go.

Bottom Line
The combination of the looming deadline along with economic recovery that is reviving takeover activity means there will be a lot of action that may interest readers inclined to a bit of speculation in the hope of short term gains. Last year's post suggested factors to consider and should help readers get started with the research that is required for success. Foresight takes more work than hindsight.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

1 comment:

Anonymous said...

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