Income Trusts: The Risks, The Returns, And The New Rules
With all the recent hoopla surrounding taxation of income trusts, I have finally relented and devoted an issue of Focus On Investment$ to this popular Canadian investment vehicle. I have resisted until now because Income Trusts are so very popular, and I prefer to search out relatively overlooked and unloved investments. But now income trusts have come under attack by a government concerned about lost taxes. Some of the glitter has come off, and investors are worried. So what do you need to know about income trusts?

By way of background, income trusts are similar to stocks, in that they represent ownership of a business. But whereas corporations pay taxes, income trusts don't. And while corporations give only a small part of their profits back to shareholders in the form of dividends (corporations generally choose to retain money in the business to provide financing for growth), income trusts are required to give back to unit holders most of their profits. So if a company can generate relatively steady earnings, they will also be able to generate relatively steady payments to income trusts unit holders.

And what tremendous payments they are! Whereas the average dividend yield of stocks is about 2.4%, income trusts pay three to four times that amount -- in other words, they can yield well over 10%. In effect, income trust investors are making a trade-off, forgoing future growth for current income, effectively saying, 'Hang the future growth, I need income now!" A yield of 10% is very attractive to retirees and others desiring regular income, who otherwise would be forced to stick with GICs paying around 2-3%. These income trust payouts simply cannot be achieved with any other type of investment vehicle, with the possible exception of high yield bonds. Hence their attraction.

However, don't be fooled into thinking that you can achieve a return of 8% or 10% without accepting some risks: October has seen income trusts fall in value by about 17% from their peak in September. So what are the risks? Up until recently, there have been two kinds of risks: valuation risk, and stability risk. You must understand these risks.

Valuation Risk is the risk that alternative investments, particularly government bonds, will become more attractive than income trusts, causing investors to sell their income trusts and buy government bonds instead. Why might this happen? Well, sharply higher interest rates could do it. After all, if you could earn a sure 7% by investing in a government bond (which by the way you cannot at the moment), you might not be so interested in an income trust which paid a bit more, but involved higher risk.

Stability risk refers to the reliability of those precious payments. It's all very well to buy an income trust yielding 14%, but if those payments disappear or are reduced a couple of years down the road, your long-term return might be quite poor. Many investors in income trusts only see the yield, or the monthly payout that they receive, and they fail to notice that there must be earnings to finance these payments. So it's important to recognize that income trusts are not guaranteed. If earnings fall, so too will payouts. This has certainly happened to a few income trusts in the past, and will likely continue to happen. Careful attention must be paid to the ability of the specific income trust to maintain its payout. The very best way to protect against this kind of problem is to either own a lot of income trusts, or to invest via a fund. Closed-end funds, the subject of my previous newsletter) are a particularly attractive vehicle for investing in income trusts.

A few weeks ago, the Canadian government added a third kind of risk: taxation risk. The government is concerned that income trusts are not paying any tax, and that this is an unfair advantage compared to corporations. So it is now expected that income trusts will soon be taxed to some extent, to equalize the playing field. It is this expectation of an impending tax that has thrown income trusts into a tailspin over the last month. It was an unexpect edaction, much like the unknown unknowns I discussed a few issues ago, and it caught income trust investors off guard. How much will the tax be? How quickly will it happen? And what will income trusts do in reaction - lower their payouts? We don't yet know.

My stance is that an examination of the worst-case scenario indicates that income trusts will continue to be rather appealing even after a tax is levied. Why is that? Well, they will still be required to pay most of their profits back to unit holders, unlike corporations. Many income trusts currently yield over 10%. If taxes take away 2%, then they will still be yielding about 8%. That is still pretty good compared to GICs, even taking into account the higher risk. I fail to see alternatives for retirees in need of income. They literally have nowhere else to go. If interest rates stop rising, and even begin to head lower again, I see an even greater need for income trusts to be included as a part of a well-balanced portfolio. Note that I said included: I normally recommend that all clients, including younger ones, hold somewhere between 10% and 15% of their accounts in income trusts, although given the recent sell-off, I might suggest 20% as not unreasonable right now. But don't go overboard and over-concentrate in just this one area.

Do I think income trusts are the only investment you need? No, there is no such thing as one best investment. But I do see them as having a role in most clients' portfolios. If you'd be interested in learning more about how you might incorporate them into your financial plan, give me a call. I can promise you that I will give you an unbiased review, with a pre-disposition to preserving capital and seeking out under-valued assets that should appreciate over time. I have over 16 years experience in financial services, both in Canada, and in Singapore and London. Call me today for a free, no-obligation consultation. It will be well worth your time.

Sincerely,

Scott Swallow, HBA, MBA, CIM