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New income trust product provides downside protection for investors

by Wayne Cheveldayoff, 2005-03-17

The financial engineers at Faircourt Asset Management have introduced a new way to invest in income trusts that reduces the risk involved.

Investors in the recently offered Faircourt income trust deposit notes will not only get monthly cash distributions from a portfolio of income trusts but they will also have downside protection – in the form of a guarantee from the Bank of Montreal that they will get their initial investment back in eight years.

Faircourt believes this new note solves a problem for investors who are holding income trusts for their cash distributions but are worried that some event – such as a significant rise in interest rates – could cause a sell-off in the trust market and result in a major decline in the value of their holdings.

The new notes, called the Faircourt Principal Protected Income Trust Deposit Notes, Series 1, are issued by the Bank of Montreal and rank with other debt issued by the bank. Despite being termed a ‘deposit note’, they are not like GICs, as they do not carry the guarantee of the Canada Deposit Insurance Corp.

While other principal-protected notes, such as one issued recently by the CIBC, provide exposure to income trusts, the Faircourt notes are the first in the market to make monthly cash distributions to investors. (The CIBC note instead provides a lump-sum return down the road when the note matures.)

The Faircourt notes also carry a leverage twist that provides up to 200 per cent exposure to the distributions and capital appreciation of the trust portfolio.

In other words, the portfolio manager will be able to borrow to invest beyond the initial amount put into the notes by investors, but it won’t be on a whim.

The decision to use leverage is linked to the positive difference between the value of the portfolio and the value of a zero-coupon bond. For example, if interest rates rise, and if this causes the value of the bond to drop more than the value of the income trust portfolio, some room to use leverage will open up and the manager will be able to borrow to buy more income trust units at their lower prices.

This facility to take advantage of a sell-off in the market is not available in the same way to investors in mutual or closed-end funds.

The Information Statement, which can be viewed at www.faircourtassetmgt.com, says the portfolio will initially consist of the 23 income trusts that are likely to be included in the S&P/TSX Composite Index later this year.

Of the cash distributions from these trusts, 75 per cent will be paid out monthly to note holders. The other 25 per cent will be re-invested in income trusts, a feature which will add to the value of the trust portfolio over time from what it otherwise would be and therefore increase the chance that the notes will appreciate in value by the end of their eight-year term.

As of February 21, the income trust portfolio was generating cash distributions of 9.06% a year, according to the Information Statement. If, for example, the portfolio is 100% invested in trusts, holders would get distributions of approximately 6.46 per cent. If leverage is used, the return could be higher, although the extra return would come only after borrowing costs are deducted.

The cash distributions from the notes would be in the form of interest, which is fully taxable as income (unless the notes are held in tax-sheltered plans like RRSPs). In other situations where investors hold trusts directly or via mutual funds, the distributions may have a more favourable tax treatment, as they consist not only of fully taxable income but also dividends (taxed at a lower rate) and return of capital (on which capital gains tax is deferred until the investment is sold).

While it may be worth it to some investors, downside protection has a cost. The “annual program fee” will be 2.85 per cent of the total value of the portfolio if it consists entirely of income trusts. By contrast, mutual funds specializing in income trusts have annual management fees a little lower and closed-end funds are in the range of 1 to 2 per cent.

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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©2005 Wayne Cheveldayoff