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Steady cash distributions make income trusts ideal investments for RRSPs

by Wayne Cheveldayoff, 2005-01-27

Income trusts are essentially high-dividend-paying equities that should have a place alongside growth equities and bonds in everyone’s RRSP.

The key attraction is the steady stream of monthly cash distributions that can be reinvested and thereby compound tax-free within the RRSP.

Cash distributions range from 6 or 7 per cent annually for relatively safe pipeline and utility trusts to 8 or 9 per cent for somewhat riskier business trusts and up to 15 per cent for oil and gas royalty trusts. A diversified portfolio could average something around 8 or 9 per cent.

Income trusts are businesses that are organized so that all taxable income, plus as much of the remaining cash flow that is not needed to maintain operations, is paid out to unitholders.

Total returns on trust units in recent years have been tremendous – fueled to a large degree by capital gains as declining interest rates have played a role in making the cash-distribution yields of trusts more attractive and rising commodity prices have boosted the valuations of oil and gas trusts.

For example, one mutual fund devoted to holding income trusts, the GGOF (Guardian Group of Funds) Monthly High Income Mutual Fund, recorded a 23.95 per cent return in the year ended December 31, 2004. The fund has had an annual average return of 20.79 per cent over three years and 21.11 per cent over five years.

Another income trust mutual fund, CI Signature High Income Fund, was up 19.86 per cent last year and recorded annual average returns of 16.78 per cent over three years and 16.51 per cent over five years.

Such high returns can’t be expected to continue indefinitely. Some analysts have warned that 2005 could be a difficult year for trusts if interest rates trend up and oil and gas prices slip. Furthermore, they argue, the flood of money into trusts as investors chase returns has boosted trust valuations beyond reason in some cases, with some trusts now trading above the target prices assigned to them.

However, if holding trusts means only collecting cash distributions of 7 or 8 per cent for the year, compare that to 4 or 5 per cent potentially from bonds and an uncertain return from growth stocks.

Choosing a portfolio of income trusts is not easy. With valuations so high, picking the right trusts will be the main factor in returns.

Ideally, one’s portfolio should contain income trusts that will be able to maintain their distributions and, furthermore, grow them over time.

Given the dozen or so trusts that have cut or ceased cash distributions in the past couple of years, it is clearly not guaranteed that a trust will maintain its distributions. One has to look quite deeply into the accounting to determine how much of eligible cash flow is being paid out.

Some trusts pay out less than they are allowed to, giving them a cash cushion in case things go wrong or to expand, while a few are actually paying out more than 100% of cash flow – something which cannot last for long.

Among the other concerns are: What are the growth prospects for the business? Does the trust have significant debt that could lead to reduced distributions if interest rates rise? Is there foreign currency exposure and, if so, has it been hedged and for how long?

With so many pieces to the puzzle of a good trust, investors who do not have the time or inclination to do the research may want to delegate this to a professional manager by investing in a mutual or closed-end fund.

Trust-oriented mutual funds have longer track records and are ideal for monthly contribution plans. But they suffer somewhat from higher management expense ratios (MERs) at around 2.5 per cent versus about 1.5 to 2 per cent for closed-end funds.

Closed-end funds, since they are publicly traded on the TSX, can be bought or sold anytime and some of the recent additions to this group, managed by the same teams that also manage mutual funds, have the added attraction of being able to borrow up to 20 or 25 per cent of net asset value in order to boost returns, although that could backfire if trust values go down.

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 and he can be contacted at

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©2005 Wayne Cheveldayoff