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Careful selection is key to staying on the winning side in the income trust market

by Wayne Cheveldayoff, 2004-03-25

Some commentators in the investment community, and in the media for that matter, fancy themselves as contrarians. When an investment sector like income trusts is hot for a time, they warn that it will soon cool off.

When someone says, “it’s different this time,” the contrarians just laugh and point to the many booms and busts the investment world has witnessed throughout history.

However, the odds are that it really is different this time – more specifically, that the income-trust sector can continue for years to come to perform well and earn money for investors just as it has in the past three years.

What the contrarians are missing is that the rise of income trusts is not just a typical market cycle.

Income trusts are popular with investors because they satisfy a need for income and provide sufficient returns for people’s portfolios as they prepare for retirement. Interest rates are just too low right now to satisfy this need.

Income trusts are part of a long wave, not a short-term cycle, and this wave is likely to get larger as the baby boomers head into their retirement years and snap up every income-producing investment in sight.

This is obvious right now in the income trust market, which continues to roll on unimpeded by the warnings.

Investor demand is triggering the launch of several new income trusts each month with cash yields in the 8 to 11 per cent range, adding to the 140-plus trusts worth $90 billion already in existence. .

Recent offerings include: CML Healthcare Income Fund, a provider of laboratory testing and imaging services; Osprey Media Income Fund, an operator of small and mid-sized newspapers in Ontario; Holiday Income Fund, a distributor of luggage and other travel accessories; and Hardwoods Distribution Income Fund, which is involved in hardwood lumber and sheet goods distribution on the West Coast.

Among the concerns being raised was that the federal government was losing too much tax revenue and would shut down the sector. This proved wrong. The federal budget made it clear that the government’s only concern was with big pension funds getting into the sector and it imposed a partial restriction on these funds. For individuals, the favourable taxation treatment remained untouched.

Some have warned of a collapse of oil and gas prices, which would hurt the oil and gas income trusts much like collapsing coal prices devastated the coal trusts several years ago. While it is possible that commodity prices could soften a bit, the odds are against a major collapse anytime soon. North American natural gas production is falling as exploration is not sufficiently replenishing reserves and OPEC is co-operating to keep oil prices at relatively high levels.

Others have raised legal concerns about unitholders being subject to unlimited liability for the operations of the trust. It’s the main reason the big pension funds have largely stayed out of the sector. However, the Ontario government has stated it will introduce legislation to fix this and other provinces are expected to follow.

Where things could get dicey for the entire trust sector, however, is if there is a sharp rise of interest rates. This doesn’t look likely in the next few months. But with the North American economy in recovery mode, it could happen later this year or in 2005.

It’s easy to understand why this could be damaging. Income trusts yielding 7 or 8 per cent would not look nearly as attractive if lower-risk bonds and GICs, currently yielding in the 2 to 5 per cent range, suddenly jump by two or three percentage points.

Also, certain debt-heavy trusts would incur significantly higher interest costs and therefore have less free cash to distribute to unitholders, which in turn would weigh on unit prices.

But not all trusts would suffer in the same way. Indeed, there is a good chance that some trusts with little or no debt and with good growth prospects could sail through largely unaffected by an interest-rate storm.

The challenge for investors, of course, is to identify and gravitate towards trusts with those characteristics.

It’s a strategy that offers the best chance of staying on the winning side and it has already been adopted by some professional fund managers.

They’ve shifted away from power and real estate trusts, which would have a high sensitivity to climbing interest rates, to business income trusts that have low debt and solid growth potential. The assumption is that growth will heal any wounds sustained from an interest rate shock.

Individual investors with business income trust portfolios would be well advised to follow their lead, and soon. Once interest rates do start rising, unit prices for trusts will adjust very quickly.

In the oil and gas sector, investors should avoid the trusts that have been paying out more than they’ve been earning and instead favour those that have held back cash to develop more wells. Those will large undeveloped land positions are the ones that will be able to grow distributions in the future even if commodity prices weaken.

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. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.



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©2004 Wayne Cheveldayoff