2003.01 Brought to you by : René Després, Financial Planner
Autonomous Partner to Le Groupe Langevin
Affiliated with AEGON.
With the kind cooperation of Talvest Mutual. Funds
2003.01 Brought to you by : René Després,
Financial Planner
Autonomous Partner to
Le Groupe Langevin
Affiliated with AEGON.
With the kind cooperation of Talvest Mutual. Funds
Risk and Trust: The risks and benefits of income trust investingIncome trusts have not just taken off in Canada—they've taken over. The majority of new equity offerings in Canada over the past two years have been companies structured as income trusts.
For mature companies, the trust structure eliminates double taxation: instead of being taxed first at the corporate level, income is passed through to investors and taxed in their hands. A trust listing can also boost share prices. Growth investors who seek sales volumes that are doubling and tripling mostly overlook the stable cash-producing assets embedded in a low-growth company. An income trust structure makes those cash-producing assets visible and investors will bid up stock prices for stable income flows.
For investors, the attraction of trusts is a constant income, somewhat like bonds, but they offer a higher yield than bonds. What makes income trusts different, however, is that they are equities, says Levi Folk, editor of "Asset Appreciation," a newsletter for investment advisors. "Investors need to understand that income trusts are riskier than bonds," he says. "They fluctuate more in price and at heart they will behave like equities."
As equities, income trusts command sizeable assets, with a market value of approximately $35 billion. This market value equals close to 6% of the Toronto Stock Exchange's market capitalization of roughly $600 billion.
Yet, institutional investors are worried about the liabilities that might result from an oil spill for an oil and gas royalty trust, or, for a real estate investment trust (REIT), a contaminated building site.
Against that worry, ARC Energy Trust, one of the oldest oil and gas royalty trusts in Canada, has argued that it's much like a mutual fund trust. Like a mutual fund, it receives income from corporations, whose liability is limited under law. In the real estate sector, it's a little different, but Ian Bacque, director of government relations for the Canadian Institute of Public and Private Real Estate Companies in Toronto, says they have sought three legal opinions on the liability risk. "They're quite clear that it's really not an issue," Bacque says.
Liability is probably the least among an assortment of risks for income trusts. "As more and more of these securities come to the market," says Rajiv Silgardo, chief investment officer at Barclays Global Investors Canada Limited in Toronto. "A fair number will be of lesser or lower quality than some of the ones that have been around for a long time."
Some newer listings may be inappropriate for income trust structure as their income sources may be overly cyclical. Trusts, which receive royalties from restaurant franchises, for example, will see receipts fluctuate as the economy, and consumer demand, expands and contracts.
Specific sectoral risks can also affect even well-established trusts.” There are risks in the oil and gas trusts from the commodity itself," says Silgardo. If oil prices decline, then oil and gas royalty payouts will decline.
In the REIT sector, hotel profits are linked to business travel, which typically is a function of the economy, Silgardo adds. With apartment REITs, vacancy rates are affected by the unemployment cycle, as well as by new construction activity. In addition, rising interest rates may depress trust prices in all sectors as investors bid up yields to keep pace with the returns on safer government bonds.
That leads to the most important risk advisors need to examine in the investigation of income trusts: income trusts are designed to produce income. Capital gains are a bonus. In the past two years, many income trust funds have achieved 20% returns, thanks to capital gains. That's unlikely to be repeated. “The fall in interest rates over the past year has boosted capital gains returns on all income trusts, much like the capital gains made on bonds,” says Folk.
Those gains are largely behind us. Future capital gains are likely to be extremely modest, on the order of 1% or 2%. So what is the future of income trusts? With an experienced manager who can separate the speculative plays in the income trust market from the stable producers, a tax-advantaged yield of 8% is more than achievable. Add in a premium for investing in the best trusts—in other words, a modest capital gain—then the return might equal 9% or 10%, roughly double the current yield on long-term Canadian bonds.
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