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New investment product splits the cash distributions of income trusts

by Wayne Cheveldayoff, 2004-08-19

Canadaís financial engineers are relentless innovators. After pioneering income trusts, which have become very popular, they have come up with a new structured product that splits the cash distributions of those income trusts in a way that creates tax advantages and greater choice for investors.

While it is not the first of its kind to be brought to market, the latest structured trust offering, known as Multi Select Income Trust, is a good example of the way the new products work.

Multi Select, which is being offered by Sentry Select Capital Corp., will be investing in a broad portfolio of income trusts that pay cash distributions.

Multi Select will then repackage these cash distributions by allocating them to two distinctly different securities issued by the trust Ė Preferred Securities and Capital Units Ė both of which will be listed and will trade on the Toronto Stock Exchange like a previous offering from Sentry Select, the Alliance Split Income Trust (TSX: ASI.UN, ASI.PR.A).

The Preferred Securities will pay fixed quarterly interest payments equal to 6.5 per cent per annum. Sine the interest will be fully taxable income, these Preferred Securities would be ideally suited for registered plans, such as RRSPs, RRIFs and RESPs, perhaps as substitutes for lower-yielding bonds.

The Capital Units will pay monthly distributions based on the net distributions that Multi Select receives on its portfolio, after paying the interest on the Preferred Securities and the costs of the structured trust, including the management fees to Sentry Select.

One feature of the Capital Units is their tax efficiency, and this is why the Capital Units are best held outside of registered plans, as their tax advantages could not be used in such plans.

Sentry Select expects that approximately 75 per cent of the indicative monthly distribution amount for Capital Units in 2005 will be return of capital, on which tax is deferred. (The amount of a distribution regarded as return of capital reduces the adjusted cost base of an investment. When the investment is sold, the difference between the sale price and the adjusted cost base is considered to be capital gain, of which under current tax rules only half is considered income for tax reporting purposes.)

By contrast, investors in a broad portfolio of income trusts, as represented by the S&P/TSX Capped Income Trust Index, can expect only about 35 per cent of the cash distributions to be tax-deferred return of capital, according to Multi Selectís prospectus filed at www.sedar.com.

The tax efficiency means that investors in the capital units will be able to keep more of their cash distributions for re-investment and building wealth than if they instead invested directly in a similar broad portfolio of income trusts.

The prospectus notes that Multi Selectís portfolio will need to generate cash distributions of 9.5 per cent a year to fund the 6.5-per-cent annual interest payments going to holders of Preferred Securities as well as a targeted 9-per-cent annual cash distribution going to holders of Capital Units.

If the Multi Select portfolio earns less than 9.5 per cent per annum, the holders of the Preferred Securities still get their interest but holders of the Capital Units will get less, because the requirements of the trust are that both Preferred Securities holders and the annual expenses of the Multi Select trust (including portfolio management fees) are paid before Capital Units holders get their allotment of what is left over.

The greater tax benefits of the Capital Units, therefore, come with a greater risk of not receiving distributions. Another consideration is that the Capital Units are leveraged, meaning that swings in the value of the underlying Multi Select portfolio will create wider swings (volatility) in the value of the Capital Units.

The prospectus says Multi Select will come to an end in just five years on September 30, 2009, although this can be extended by a majority vote of Capital Units holders. On termination, the Preferred Securities holders are to be paid out in full, while the Capital Units holders get what remains (which could well be more than what they paid if there is a net overall capital gain in the underlying portfolio).

There is a lot to consider in weighing the benefits of participating in a structured product like this.

The Preferred Securities can be compared to a 5-year bond. The 6.5-per-cent yield is higher than what is generally available for high-quality bonds and GICs at the present time. But there is a risk attached. While the Preferred Securities have good security, since they will start off being backed by a portfolio of income trusts that is double the size of the Preferred Securities outstanding, it cannot be said that a loss would be impossible. Sentry Select is an experienced manager in the income trust sector and it is highly unlikely that the underlying portfolio in just five years time would be worth less than half of the initial starting amount, but one canít rule it out completely.

With the Capital Units, the key considerations are the tax benefits and the greater volatility of returns compared with regular mutual funds that invest in income trusts. If things go well for the underlying portfolio, holders of the Capital Units could come out ahead of those in regular mutual funds on both a total return and an after-tax basis.

But an additional consideration for those holding income trusts directly or via low-fee index funds is Multi Selectís annual management fee of around 1.8 per cent of the Net Asset Value of the Capital Units. The managers will have to do a good job of outperforming the generally trust market or the fee could eat into any expected tax benefits.

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