MarketNotes

Trusts in the future: Can you still trust in income trusts?

Income trusts have had a great run since their popular emergence a decade ago, but what does the future hold? Now that the rules are changing around dividends, are income-oriented investors going to allocate a larger portion of their portfolios to dividend-paying stocks at the expense of income trusts? Is quality being sustained in the catagory as trusts rush to meet the seemingly endless demand? As well, are income trust investors really conscious of the risks inherent in this asset category? Let's begin at the beginning.

A Brief History of Trusts

It's opportune that, at time of writing, we are celebrating the 10-year anniversary of the grand-daddy of the business trust world - the so-called 'origin of the species' - that of Labrador Iron Ore Royalty Income Fund (we'll just call it the Labrador Income Fund). It went public as a spin-off of Norcen Energy, a conglomerate that was right-sizing. At that time, income trusts (which include energy, business, utility and REITS-Real Estate Income Trusts) were quite rare.

The very first one was taken to market in 1928: the Economic Investment Trust Limited, which is still around today (EVT.TO). In 1984 the first small business trust (actually headquartered in the U.S.) called Public Storage Canadian Properties (PUB.TO) was floated, followed by the first energy trust (Enerplus Resource Fund, ERF-UN.TO) in 1987 and the first REIT in 1993 (Canadian Real Estate Investment Trust, REF-UN.TO).

Until the Labrador Income Fund, however, trusts just didn't get much respect.

A Growth Story

Canadian income trust market capitalization was still nascent even after Labrador Income Fund (proceeds of $300 million) was sold. However, they caught on fairly quickly. The 175 income trusts listed on the TSX in 2004 represented more than $118 billion in assets.

Investors liked them for a number of reasons. At a time of relatively low yields on traditional income-generating investments, income trusts promised more of a good thing. The flow-through nature of trusts translated into reduced corporate taxation and higher distributions for investors.

The nature of the distributions also helped increase the popularity of trusts. Since distributions in part take the form of return of capital - on which no tax is payable - taxation is deferred until the trust is sold, at which point the investor pays capital gains based on a cost base that has been adjusted downwards.

Because of their distinctive tax advantages, when compared with investments yielding interest income - such as bonds, GICs or money market instruments - income trusts can offer very attractive after-tax returns.

Not without Risk

Although the perception of income-oriented investments is that they carry reasonably low levels of risk, income trusts have to be viewed as equities, not fixed income (e.g. bonds) since their potential risks and returns are much more similar to company stock than to company debt.

A few areas to consider in regard to the risks of income trusts:

  • No guarantees – unlike bonds (especially those issued by the government of Canada) and GICs, there is no safety net should tides turn against the income trust's underlying business plan (lower commodity prices, competition, falling rents, lower throughput for pipelines). Furthermore, income trusts may increase or decrease distributions depending on profits and cash flows – so the 'dividend' or 'income' provided is not set in stone to any degree.
  • Lack of diversification - unlike company shares, income trust securities are dominated by energy trusts (46%) but also include business trusts (31%), REITs (13%) and power and pipeline trusts (10%). In the business trust segment, typical underlying businesses are mature, generating significant free cash flow, and not requiring additional capital investment. While this means that these businesses are typically stable, it limits diversification into newer, more dynamic industries.
  • Growth restrictions - income trusts generally have a lower potential for growth since their cash flow is continuously siphoned out of the trust and unavailable for management to initiate new, potentially higher margin business ventures, re-invest in depreciating capital or institute higher maintenance expenditures.

The impressive run that income trusts have enjoyed over the past 10 years raises some natural questions for investors. How long can it continue? Are there fundamental issues within the sector that will lead to correction? Canadian investors might want to consider participating in this sector through investments that offer the security of 100% principal protection.

A recent principal protected note, the ONE Financial Profit Lock-In & Cashflow Note, Income Trust LEADERS™ Class offers exposure to leading Canadian income trusts with complete principal protection and automatic daily lock-in of any growth. With this note, no matter what the future holds for the income trust sector, investors are protected. The reasons to trust in income trusts have never been greater.

This article was produced by ONE Financial Corporation and is written for informational purposes only. It represents ONE Financial's interpretation of market conditions at the time of publication.

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