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The ABCs of income trusts and why investors love them

by Wayne Cheveldayoff, 2003-10-11

Individual investors in Canada have flocked to income trusts for a very good reason: with only a few exceptions, they have been reasonably stable and provide significantly more income than bonds.

In fact, the return on investment (cash payout plus capital gain) for some trusts in the past three years has been more than 20 per cent a year -- beating the performance of the TSX/S&P index and most other investments by a wide margin.

Here is how they work. The trusts essentially are businesses that get revenue from some source. All or most of the income (after expenses are deducted) is passed through to the investors who hold the units of the trust. Whatever income taxes are due are paid by the unitholders, not the trust.

This flow-through mechanism is the key difference from how it works with a normal corporation. A corporation has to pay income taxes on the income and it is only what is remaining after taxes that can then be paid out in the form of dividends. Naturally, due to this taxation difference, a corporation would have a much lower dividend yield than the cash yield of a trust operating the same business.

The cash yield – meaning the annual cash payout divided by the price of the units – is what attracts investors to trusts, although the stability of the payout and the potential growth of the payout also enter into the equation.

For oil and gas trusts, the cash yield depends on a lot of things, but it is usually in the range of 10 to 20 per cent a year, reflecting the fact that some of the cash being paid to unitholders represents a return of capital as the oil and gas assets are depleted.

In the case of real estate investment trusts (REITs), the cash yield is normally less, in the 8 to 12 per cent area, because the REIT assets are usually solid buildings that will be around for a long time, although there is still risk from an unexpected cut in rental income or a possible downturn in real estate prices.

The same range of cash yields also applies in the newest trust sector, known as special business income trusts (sometimes known as income funds), which cover a wide variety of businesses including cheque printing, seafood processing, trucking, yellow pages publishing, meat processing, cinemas, restaurant chains, etc.

Virtually any business can be turned into a trust if the underlying income stream is stable enough. The market value of the more than 100 trusts listed on the TSX exceeds $120 billion and more trusts are being created each month.

Is this a bubble? Not by the usual definition of a bubble, which suggests prices beyond reason. Rather, the cash yields are still attractive and the quality of the trusts being issued is on balance better now than it was. The reason is that a year or two ago, the investment dealers that underwrite the new trusts were selling the units mainly to less-sophisticated individual investors. Now that institutions are also buying them, professional money managers are applying greater scrutiny to the details and the quality of new trusts is actually improving.

This is not to say that trust values are safe for all time. Present valuations look reasonable given where alternative bond yields are. But the trust sector could take a valuation hit if interest rates rose dramatically. A trust yield of 8 per cent looks good when 10-year government bond yields are under 5 per cent. But if bond yields rise to 7 or 8 per cent, trusts would have to drop in value in order to yield more to compensate for the greater risk involved in trusts.

Also, like any business, individual trusts could have problems. Indeed, a few (individual trusts in hotels, aerospace parts, and cargo handling in ports) already have had to reduce or suspend cash payouts because of souring business conditions. In those cases, the prices of the trust units have tumbled. If oil and gas prices drop substantially, the same may happen in that sector.

All trusts have websites and make it relatively easy for investors to get detailed information. But comparisons are tough. There isn’t a central website that lists all the trusts and their yields. Even if there were, it would take a lot of digging to figure out why one REIT yields 8 per cent and another yields 11 per cent. Also, the accounting can be convoluted, and the price earnings ratio that is often used to compare stocks has little relevance because trust accounting is different.

Two rating agencies, Standard and Poor’s and Dominion Bond Rating Service, have published stability ratings on their websites for a few of the trusts, but not most. Standard and Poor’s, for example, only rates trusts that pay it a fee for the rating, and most don’t.

Rather, the best sources of information on trusts are the few major investment dealers who can afford to pay analysts to make comparisons and recommendations. For individuals wanting access to this research, it means setting up an account and paying a broker full-service commissions on purchases and sales.

A lot of investors have invested in mutual funds or index funds that invest in a basket of income trusts, thereby getting the benefit of diversification and, in some cases, professional portfolio management and tax benefits. Management expense ratios for these funds range from 0.5 per cent to 2 per cent, which of course eats into the return. However, such funds have become so numerous that an average investor would need the help of an investment advisor to sort through the alternatives.

An advisor may also be helpful in figuring out the taxation of trust payouts, which are normally some combination of taxable income, dividends, and return of capital. These vary greatly from trust to trust and, for each trust, from year to year.

A taxpayer with a top marginal tax rate of 46 per cent would pay this rate on the portion that is taxable income, about 35 per cent on dividends, and would be exempt from paying income tax on return of capital until the trust units are sold. The amount returned as capital reduces the adjusted cost base of the investment and therefore it is effectively taxed as a capital gain (only half of which would be subject to the 46 per cent tax rate).

One concern about trusts is that, unlike shareholders of a corporation, unitholders may be liable for any losses a trust may incur if it goes bankrupt. This is a theoretical concern because the issue has not been tested in a court of law and lawyers, in any case, are divided over whether unitholders would be held liable.

This liability concern is one of the reasons why institutional players, like pension funds, have in most cases stayed away from trusts, and why Standard and Poor’s has not included trusts in the TSX/S&P index. At the request of the trust sector, the Ontario and Alberta governments have introduced legislation to ensure unitholders are not liable for losses. In the meantime, some institutions are investing in trusts through limited companies (to protect other assets).

Some have suggested that the popularity of trusts will, in the end, be their downfall because they mean a loss of current tax revenue and governments will move to close them down. While anything is possible, this is unlikely, because taxation is not being evaded, it is just being deferred in some cases. This occurs elsewhere in our tax system (examples include RRSPs, RESPs, RRIFs), so trusts probably will continue to be tolerated.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. He can be contacted at wcheveldayoff@yahoo.ca.

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©2003 Wayne Cheveldayoff