How to invest in income trusts

Although interest rates have bumped up from their 40-year lows, the returns on traditional safe haven investments like GICs continue to be meagre. That’s left many people scrambling to find alternatives that will generate more cash flow.
 
Many have turned to a new type of security, the income trust, enticed by the promise of yields in the range of 8%-10%. In many cases, they have been severely disappointed.
 
There are several kinds of income trusts and it’s important to understand the distinctions between them. I classify them as follows:
 
Industry income trusts. These specialize in a specific area of the economy, such as the energy sector or real estate (in the latter case they are known as REITs). The trust holds assets, such as oil wells or shopping malls, that generate cash flow. Most of the profits (usually 80%-90%) are distributed to unitholders on a monthly or quarterly basis. However, the distributions are not guaranteed and will be significantly affected by such factors as the world price of oil.
 
Corporate income trusts. These operate on the same principle, but the underlying asset ia single business – a mattress factory, a cold storage company, A&W burger outlets, etc. If the underlying business is doing well, unitholders receive generous distributions. If it does poorly, they may get nothing – there have been cases in which trusts have been forced to suspend distributions because there were no profits to pay out.
 
Portfolio income trusts. In this case, the trust invests in a portfolio of securities, usually common or preferred shares. The managers employ sophisticated techniques like covered call writing to generate income. Some of these trusts guarantee to return your capital after so many years. However, that guarantee comes with a price. To achieve it, the trust invests a significant portion of its assets (sometimes more than 50%) in a strip bond that matures on the date the trust is wound up. This greatly reduces the cash available to invest in the securities that are supposed to produce the projected income. Earlier this year, many unitholders in such trusts were shocked to learn that their distributions were being cut when falling stock prices threatened to erode the capital base to an unacceptable degree. The guarantees are still in place, but if investors bail out now, they’ll take a big loss. They have to hold until maturity to get their capital back.
 
Clearly, there is significant risk involved in income trusts. But with interest rates still low, they remain enticing. If you want to add some to your portfolio, here are some tips.
 
Understand the risk. These are not government bonds. Distributions may seem high now, but they are not guaranteed. Nor is your principal, except in the case I’ve just described.
 
Look at the track record. Some trusts have been around for several years. See how they’ve done in good times and bad. Look especially at the distribution record – how predictable has it been? TransCanada Power LP, for example, has increased its payment every year since it was launched in 1998. In 2001, it paid out $2.46 per unit. At the other extreme, the Mulvihill Summit Digital World Fund slashed its distributions from $2.35 in 2000 to just $0.95 in 2001, as the high-tech sector crashed.
 
Avoid new issues. They’re very difficult to assess. Some will do well, but others won’t. Go with the known quantities.
 
Consider a fund. There are several funds that specialize in income trusts. They enable you to spread your risk while handing the responsibility for selection to a professional manager. Some have been in business for several years and have a good track record. I especially recommend Guardian Monthly High Income Fund, Saxon High Income Fund, Renaissance Canadian Income Trust, and Bissett Income Fund.
 
But remember – even with a fund, there are no guarantees. If you want higher yields, you have to accept more risk. The two go hand-in-hand.