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

• 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

Disclaimer
Note that this post is not meant to be an investment recommendation. It is merely to illustrate current conditions.

ETFs and Mutual Funds - Calculating Capital Gains

The previous post on this blog explained that an investor must calculate the capital gain when he/she sells a mutual fund or ETF and must report that gain on his/her annual tax return. This post now explains how to figure out the capital gain.

Step 1: The first number to calculate the gain is the amount you receive, quite straightforwardly the net cash after deduction of fees and commissions incurred by the sale.

Step 2: The second number is the cost, or the Adjusted Cost Base (ACB) in tax parlance. The formula is:

ACB =

Total Paid to Purchase Shares/Units (plus fees and commissions)
+
Reinvested Distributions (all of Capital Gains, Income and Dividends)
-
Return of Capital (ROC)
-
ACB of Previous Sales of Shares/Units

The ACB changes with each purchase, distribution and ROC over the years the fund is owned. The ACB is a running total for the fund. There is no selling oldest or newest shares first, they are all mixed together.

Mutual fund companies generally keep track of the ACB and you can see this on statements or obtain this information from them but they also advise to do the calculation yourself since most disclaim liability for possible inaccuracy due to situations such as deemed dispositions and incomplete return of capital deductions.

The ETF companies cannot provide the ACB of your holdings (iShares explains why in this FAQ); you must do the calculation yourself for ETFs using the data on the T3 slips and brokerage detail statements for the T3 (box 21 = capital gains; box 42 = ROC).

It is important to track ACB because if you do not, you will be paying taxes twice on reinvested distributions - once when reporting the gain on the T3 and again when you sell part or all of the holding. Remember, the higher the ACB, the less the capital gain and the less tax there is to pay.

The chart below shows examples of ACB tracking calculations for a mutual fund and for an ETF. Note especially (see yellow cell) that when an ETF reinvests capital gains distributions, no additional shares are issued or created, as explained in the iShares FAQ linked above.


The easiest way to keep track of ACB is to do an annual update when the fund companies announce their tax distributions and issue T3 slips for the previous year, sometime around the end of February. The websites of ETF and Mutual Fund companies disclose the annual distributions on a per share/unit basis, which enables the re-construction of past years if statements or T3 slips have been mislaid.

Additional Info:
Managing Taxes from iShares Canada
ETF Tax Information page at Claymore Canada

Disclaimer: this post is not to be construed as advice; it is for information purposes only. Consult a tax accountant or financial professional for proper advice.

The Mystery of Fund Capital Gains in 2008 Explained

Investors who own ETFs and mutual funds in taxable accounts (i.e. this does not apply to tax-protected accounts such as RRSPs) may be surprised and puzzled this year to receive T3 tax slips that show capital gains to be reported on their income tax return. After all, in 2008 stock markets had one of the worst years in living memory with the TSX down 35%. How could there be any gains one might ask?

Taxable Capital Gains When the Fund Sells: Investor Sees no Cash
Capital gains (or losses) arise when the fund sells one of its holdings and makes a profit during the year; the investor has not sold anything, the fund has. The net of all the sales during the year is calculated by the fund and the capital gains are attributed to the investor for purposes of tax reporting. Such gains are not usually paid out in cash to the investor; instead they get reinvested within the fund through new purchases.

The TSX had reached a peak in mid-June 2008, so stocks sold within a Canadian equity fund up to that point could well have made a capital gain and if few stocks were sold at a loss during the subsequent downturn before the end of the year, the fund might be reporting a net capital gain for 2008. That does turn out to be the case for instance, with the popular iShares Canadian Large Cap 60 Index ETF (symbol XIU). A press release of Dec.24th says XIU has generated a reinvested distribution of $0.14652 per share, which investors will soon see in box 21 on a T3 slip from their broker to be included on their tax return.

Taxable Capital Gains When the Investor Buys(!)
An investor who buys a fund late in the year just before the year-end capital gains distribution can end up paying tax for gains made much earlier in the year. Funds use the list of owners as of a certain date (termed the record date) to parcel out the year's gains, most often December 30th. The T3 the investor receives tells the tale. It may be better to defer the purchase till the new year. Fund companies normally publish year-end distribution estimates in advance of the record date so that investors can avoid the nasty tax surprise if a big capital gain is in the offing.

Taxable Capital Gains When the Investor Sells: Investor Sees Cash
A separate taxable capital gain (hopefully! or perhaps a loss) occurs when the investor sells all or part of a holding in a fund and the proceeds exceed the net purchase cost. The investor will NOT receive any T3 tax slips from the fund company to use on his/her tax return. It is up to the investor to calculate and report the gain.

Additional Info:
ETFs - iShares Canada Distribution History links for each fund - e.g. for XIU
Claymore Canada Tax Information Guide for 2007 (2008 tba) covering all its funds

Mutual Funds - follow links to fund companies at FundLibrary.com and look for Tax or Distribution info at each company's site; a typical handy guide is Mackenzie's Mutual Fund Tax Guide

As always, this post is not to be taken as advice. If you are unsure how to handle distributions, contact an accountant or other financial professional.

Investing During Deflation

How quickly things change. A few months ago, the big fear was inflation as gas, food and other prices climbed drastically. Suddenly deflation is on the minds of governments and central banks - see Canada Faces Deflation Threat from Canada.com.

Deflation is the opposite of inflation. Instead of rising prices, deflation is generalized and persistent falling prices, reflected in negative changes in the Consumer Price Index. With deflation, a dollar tomorrow is worth more than a dollar today.

Just as inflation presents challenges and opportunities for the investor, deflation does too. The investing winners and losers differ, and thus also the investments to survive and thrive in that environment.

Creditors (those who have lent out money) benefit, and debtors (those who have borrowed) suffer. Owning debt securities pays off, even when interest rates may be low since part of the payoff is that the future dollars are worth more. The longer the debt lasts and deflation continues, the greater the benefit, so longer maturity debt benefits most.

However, the conditions that create deflation, like a precipitous fall in demand in a weak economy with attendant job cuts, business failures and such, also considerably raise the risk of default. The safer the debt, the better. At the top of the list is government debt or government-guaranteed debt, the theory being that governments can avoid defaulting by raising taxes. Some governments are, of course, more likely to pay your money back than others, the top of that list generally considered to be the US government. Debt rating agencies do rate government debt - see previous post Seeking Safety. Due to risk of default, corporate debt tends to do less well, though debt of companies perceived to have the ability to survive, like many utilities, may be ok.

Sample investments: Government of Canada 30 year maturity (see various options at CanadianFixedIncome.ca), US 30-year Treasuries, GICs

Equity - the debtor effect carries through into companies/equity. Some companies will struggle and others will thrive.

Losers:

• Companies with a lot of debt on their balance sheet.

Winners:

• Companies with lots of cash or free cash flow will be able to acquire the weak at bargain prices.
• Companies able to maintain profit margins will do well. That includes those which can reduce their costs as quickly as their prices fall and those which can maintain their own prices even as prices fall generally.
  

It is impossible to make statements that entire sectors are good equity investments during deflation. The only way ultimately is to dive into the financial innards of each company. The disciplines of fundamental analysis and value investing serve the investor more than ever,

One interesting security that stays fine in either inflation or deflation is real return bonds issued by governments. In addition to their safety, when there is inflation, the government ratchets them up by CPI to maintain purchasing power and when deflation occurs, they go down by CPI, but again their purchasing power stays the same. You neither win nor lose, just get a steady return in real terms. More at ByloSelhi - RRBs.

Though the idea that things might cost less is certainly attractive from a consumer point of view, deflation is symptomatic of problems in the economy. Governments and central banks are highly likely to step in to stop deflation so in addition to the best type of investment, one must consider whether it will actually occur.

Further reading:
Implications of Inflation and Deflation for Investments from Yanni Partners
How Does One Invest for Inflation and Deflation? at Mish's Global Economic Trend Analysis

Closed-End Funds - Opportunity vs Risk

A Closed-End Fund (CEF) is an intriguing beast that currently offers potentially highly attractive investment returns but, as usual, there are risks.

The CEF is similar to the mutual fund and the exchange traded fund (ETF), as seen in the following table.

What makes the CEF intriguing is that unlike both mutual funds and ETFs, a CEF's market price may vary considerably from the sum of the values of the securities held by the fund, called the Net Asset Value (NAV). Most commonly the CEF's market price is lower by 2-6% than the NAV, which is termed trading at a discount. Sometimes, however, there is a premium.

The following partial list from GlobeFund's Closed-End Fund report, sorted by discount/premium, shows that the divergence at the moment is extreme with many enormous discounts.

More than half of 225 Canadian CEFs are currently trading at over 10% discount. NAV is supposed to represent the true value of the fund holdings and CEFs are obliged to report changes as often as the market price of their holdings change. Buying a heavily discounted CEF is an opportunity to buy a bargain. The "% off" sale may now be at a peak.

Why the steep discounts and is the opportunity real? The answer arises from the risks of CEFs:

• Illiquidity - CEFs trade in lower volumes and may be harder to sell quickly, especially so with smaller funds; this is considered to be a permanent reason for a small discount
• Leverage - some funds use leverage or borrowing to enhance returns, which works fine in good times but punishes in bad times; the credit crunch combined with leverage is what appears to be the undoing of Bayshore Floating Rate Senior Loan Fund (TSX: BIF.UN) first on the list at a 92% discount and about to be wound up
• Credit Quality - fixed income CEFs may suffer when worries about credit quality of holdings increase, even if the official ratings stay the same
• Equity Concentration - a CEF with a high concentration of shares in a sector or a particular company will have higher volatility. Perhaps this is what is affecting (66% discount to NAV) First Asset PowerGen Fund (TSX: PGT.UN), which has around half its assets invested in a private company developing wind farms and other renewable power generation
• Market Sentiment - since a CEF's price is market-determined separately from the NAV, the CEF as a vehicle may fall out of favour independent of its holdings; many CEFs do not have redemption privileges or repurchase schemes that keep price in line with NAV, unlike ETFs; the "flight to safety" of the current financial crisis may be especially harming CEFs. If fear is driving higher discounts, in some cases there may be true long term bargains amongst CEFs.

What I think CEFs are best suited for:

• bargain hunting, where the discount is large and where the NAV appears to be solid after due diligence research into the CEF and its holdings
• specialized sectors such as high yield bonds, US municipal bonds, emerging market equity and debt, small cap companies, where a fund is desired but low-cost ETFs or mutual funds are not available; some asset classes where CEFs are more numerous and successful -
• a long term investment to produce regular income at a higher return (from the discounted NAV)

Where to Find:
Listings & CEF Company Links

• Canada: GlobeFund Closed-End Funds report
• US: Closed-End Fund Association

Primers

• Wikipedia Closed-End Fund article
• Closed-End Funds 101 at CEFA
• Investing in Closed-End Funds: Advantages and Risks at CEFA

ETF and Mutual Fund Distributions Explained

Investors who own ETFs and mutual funds in taxable accounts (i.e. this does not apply to tax-protected accounts such as RRSPs) may be surprised and puzzled this year to receive T3 tax slips that show capital gains to be reported on their income tax return. After all, in 2008 stock markets had one of the worst years in living memory with the TSX down 35%. How could there be any gains one might ask?

Even in normal years of market advances, an investor may wonder why there are taxes to be paid if none of the investment was sold and no cash received.

The explanation revolves around distributions. Confusion arises because the word distributions is used to refer both to cash paid out to investors and to income attributed to investors for tax reporting purposes. In both cases, distributions consist mainly of capital gains, interest and dividend income generated during the year by the stock or bond holdings within the fund.

All Income Taxed as if Received by Investors
All ETFs and most mutual funds are structured as trusts, which means that to minimize taxes they pass along all income to investors to be taxed in the investors' hands. "Pass along" often means an actual cash payment to the investor but it may not.

Income Reinvested Automatically by Mutual Fund is Taxable
Mutual funds offer investors who want to reinvest income the convenient optional service of automatically buying more fund units with the profits instead of going through the complication of sending out cash only to have the money sent back to buy more units. The investor never sees the cash but receives the profits so it should not be disappointing to be required to pay taxes on the profits.

In the case of ETFs, interest and dividends are always paid in cash to investors either monthly, quarterly, semi-annually or annually. There is no option to have this income automatically reinvested as with mutual funds. The Managing Taxes document from iShares Canada explains why.

Cash Distributions May be Boosted by non-Taxable Return of Capital
It happens fairly often that funds distribute more than their income in a year. The excess is in effect paying back some of the investor's original investment and is termed a Return of Capital. This is not taxable.

Taxable Capital Gains When the Fund Sells: Investor Sees no Cash
Capital gains (or losses) arise when the fund sells and makes a profit during the year; the investor has not sold anything, the fund has. The net of all the sales during the year is calculated by the fund and the capital gains are attributed to the investor for purposes of tax reporting. Such gains are not usually paid out in cash to the investor; instead they get reinvested within the fund through new purchases.

The TSX had reached a peak in mid-June 2008, so stocks sold within a Canadian equity fund up to that point could well have made a capital gain and if few stocks were sold at a loss during the subsequent downturn before the end of the year, the fund might be reporting a net capital gain for 2008. That does turn out to be the case for instance, with the popular iShares Canadian Large Cap 60 Index ETF (symbol XIU). A press release of Dec.24 says XIU has generated a reinvested distribution of $0.14652 per share, which investors will soon see in box 21 on a T3 slip from their broker to be included on their tax return.

Taxable Capital Gains When the Investor Buys(!)
An investor who buys a fund late in the year just before the year-end capital gains distribution can end up paying tax for gains made much earlier in the year. Funds use the list of owners as of a certain date (termed the record date) to parcel out the year's gains, most often December 30th. The T3 the investor receives tells the tale. It may be better to defer the purchase till the new year. Fund companies normally publish year-end distribution estimates in advance of the record date so that investors can avoid the nasty surprise if a big capital gain is in the offing.

Taxable Capital Gains When the Investor Sells: Investor Sees Cash
A separate taxable capital gain (hopefully! or perhaps a loss) occurs when the investor sells all or part of a holding in a fund and the proceeds exceed the net purchase cost. The investor will NOT receive any T3 tax slips from the fund company to use on his/her tax return. It is up to the investor to calculate and report the gain.

Additional Info:
ETFs - iShares Canada Distribution History links for each fund - e.g. for XIU
Claymore Canada Tax Information Guide for 2007 (2008 tba) covering all its funds

Mutual Funds - follow links to fund companies at FundLibrary.com and look for Tax or Distribution info at each company's site; a typical handy guide is Mackenzie's Mutual Fund Tax Guide

As always, this post is not to be taken as advice. If you are unsure how to handle distributions, contact an accountant or other financial professional.

ETFs - What are They Good For?

ETFs are in the news these days. Jonathan Chevreau's November 6th column at the National Post described the curious situation of significant net withdrawals in September and October by Canadian investors from mutual funds while certain Exchange Traded Funds (ETFs) saw large net purchases.

Their being in the limelight does raise the question of what ETFs are, their strong and weak points and why they might be attractive to an investor.

What are ETFs?
Exchange Traded Funds are funds that hold numerous individual stocks or bonds. ETFs are bought and sold as shares on stock exchanges (thus the name). Each share owns a tiny part of dozens, hundreds or even thousands of individual stocks or bonds. ETFs are built to copy the compostion of an index, such as the TSX60, the S&P500, the Dow Jones or some other index, such as the UK FTSE, the Eurozone, the Far East, commodities, currencies, large/small companies, or sectors such energy, mining, financials, real estate etc.

The number and variety of ETFs is growing steadily. As of early November 2008, there are over 800 US-exchange traded ETFs and 60-odd Canadian-traded ETFs available to a Canadian investor through any discount broker.

More background:

• Canadian FinancialDIY on ETF Screeners, Tools and Primers
• Seeking Alpha's ETF Resource Page
• Shakespeare Discusses ETFs and Compares Them to Index Mutual Funds
• Stock-Encyclopedia.com lists all US and Canadian ETFs in one place
• The New Investment Frontier III, detailed and practical book sub-titled A Guide to Exchange Traded Funds for Canadians by Howard J. Atkinson with Donna Green
  

Strengths and Weaknesses of ETFs
The following chart should be self-explanatory, except for the last line, which is deliberately repeated! An index fund will necessarily do no better (actually, a little less by the amount of costs the fund incurs) than the index it tracks, the average of that particular market. That is bad in the sense that you will never get rich quick through amazing returns. But it is good in the sense that the vast majority of mutual funds over any extended period of years under-perform the market (see the latest results from Standard and Poor's SPIVA Canada Scorecard where for example, only 6% of activle-managed Canadian equity mutual funds outperformed the TSX index over the past 5 years ).

What ETFs are Best Suited For
Given their characteristics in comparison to individual stocks and bonds and mutual funds, here is how I believe ETFs can most be most useful to an individual investor:

• Buy and hold passive investing with low time and attention needed for portfolio management
• Portfolio-oriented investing where diversification, deliberate asset allocation with non-overlapping funds, infrequent rebalancing (max once a year) and risk control are key to the investment approach
  
• Long-term investing
• Fixed income bond holdings (and like all fixed income, ideally held within a registered account to minimize tax from interest income)
• Equity holdings in taxable accounts
• Larger new amounts to add to a portfolio (e.g. a $10 commission on a $1000 purchase is 1% initial cost, about the max I would accept for myself)
• Larger market cap equity holdings and developed country markets, since these are the most efficient and where it is most likely that mutual funds will not outperform; conversely, small caps and emerging markets are where mutual fund managers have better chances of outperforming

Whether it is the inherent qualities of ETFs or some other factor that caused people to buy them while mutual funds were being sold off recently is open to debate but their value and usefulness is certain.