Crunch time for trusts?

Paul Bloom is one of those rare money managers who doesn’t pull his punches. He calls them as he sees them, good or bad, even if it may mean discouraging investors from buying into his funds at times.

Bloom manages the Citadel group of funds that trade on the Toronto Stock Exchange. The funds specialize in income trusts and Bloom has developed a reputation as one of the country’s leading experts in this burgeoning field. He is also becoming known for taking strong positions. Last fall, when income trust IPOs were swamping the market in a tidal wave of new products, he was one of the main players in an institutional buyers’ strike. For a period of time, the Citadel funds refused to participate in new public offerings.

The tactic worked. Several IPOs were pulled or postponed and the frenzied market regained some measure of normalcy.

Last week, I had a lengthy discussion with Paul Bloom about the state of the income trusts market today. Low interest rates have pushed up the prices of many trusts, reducing yields to their lowest levels in years. What, I wondered, was he doing in the light of this?

Sell, sell, sell
</trng>His reply was succinct and unambiguous: “We are selling, selling, selling.”

He went on: “There is far too much money chasing these funds. They are all very overvalued on any realistic basis. All the good news is taken as a reason to buy. All the bad news is being ignored.”

These comments are consistent with my analysis. While I do not expect a collapse in the income trusts market, I do see a correction coming. That’s why I’ve recommended that our readers take profits in trusts like North West Company Fund (TSX: NWF.UN) and Northern Property REIT (NPR.UN). I have also changed my position on such high-quality trusts as Davis + Henderson (TSX:DHF.UN), RioCan REIT (TSX:REI.UN), and TransCanada Power LP (TSX:TPL.UN) from Buy to Hold.

Bloom’s current strategy is to build cash positions in his funds, although not to the point where distributions might be jeopardized, as one newsletter suggested. He regards maintaining distributions as one of his primary obligations to investors, along with capital preservation.

“This means I will underperform for a period of time if the market continues to go up,” he admits. “But all of a sudden everyone will say it was smart to get out when we did.”

He used this approach once before, at the top of the market in 1998 when income trusts were still in their infancy. It worked well then; he had plenty of cash at the bottom of the cycle and was able to buy good-quality trusts at cheap prices. He thinks the same thing will happen again.

Next page: What you should consider

Professional money managers aren’t always right, but they’re on-target more often than amateurs, which is why they get paid the big bucks. So if you’re an income trusts investor, here are three lessons you might want to take away from this.

1) If you have been holding your units for some time and have big gains, consider taking some of that money off the table for now. Sell part or all of your position and sit in cash until the expected correction, then re-purchase at lower prices.

2) Investors who don’t want to sell because they need steady income should have some cash reserves available so they can average down when prices pull back and yields rise.

3) This is not a good time to aggressively add new positions to your income trusts portfolio. Be very selective in your choices, or put your money into conservatively-managed funds and let the managers worry about what to buy and what to sell.

Let me close by re-emphasizing one point: I do not, repeat not, expect a collapse in the income trusts market along the lines of the high-tech debacle. Trusts as a group are expensive, but they aren’t at anything like the absurd valuations we saw during the tech bubble of the late 1990s and early 2000.

Rather, what I expect is the kind of normal correction that always occurs when markets become expensive. A pull-back on the order of 10 per cent to 15 per cent would appear to be a reasonable downside estimate. And it may not happen for some time, given the current level of interest rates and the weakness of the economy, so there is no need to panic.

Also, remember that a correction in the market price will have no effect on the cash flow from a quality trust. As long as the underlying business remains sound, you’ll still receive your regular distributions. RioCan, for example, will continue to pay out 9.5c per unit each month, even if the price drops back to $13 from its current level of $14.37. The difference is that those who buy shares today will receive a yield of 7.9 per cent, while those who wait and buy at $13 will get 8.8 per cent.

So if you want to get top long-term returns from your income trusts, your best course is to buy high-quality products when they’re trading at low levels. Then you can hold for as long as you want and not worry about market price fluctuations.