Investors seek better returns

With interest rates at their lowest levels since the days many of us were in high school, the challenge of generating decent retirement income from our savings has become daunting. And, in these turbulent times, low-risk investing has become expensive.

In fact, you’re likely to earn a negative real return when taxes and inflation are factored into the rates being offered on guaranteed investment certificates (GICs), government bonds, Canada Savings Bonds (CSBs) and other low-risk securities.

You have two choices:

• Accept this pittance in exchange for safety
• Look at more risky alternatives.

Some prospects
If you decide on the latter course, don’t go too far out on a limb. Choose moderate-risk securities and only commit a portion of your assets to them.

One little-known possibility is an income trust (IT). Designed to generate above-average cash flow while preserving capital, IT portfolios may include shares in royalty trusts, real estate investment trusts (REITs), high-yield bonds and common stock.

Cash flow on these investments comes from dividends, interest, rental income, capital gains and coved-call writing, depending on the composition of the portfolio. Most trusts pay income monthly or quarterly.

The cash-on-cash yield of an IT is attractive. Projected returns are always higher than prevailing interest rates (an eight to nine per cent annual return is the typical goal). Several-but not all-of these trusts have been able to deliver on their promises.

As well, there’s a danger that, although the trust makes its planned distributions, the underlying value of the portfolio itself (known as the net asset value, or NAV) will decline. In other words, delivering on scheduled income payouts could mean your capital base is eroding.

Pros and cons
Worse, if the units are held outside a registered plan, you’ll have to pay tax on the income you receive, but will get no credit for the loss of capital unless you sell. This is exactly what happened to many income trusts in the bear market of 2000-01.

The flip side is that when markets turn around, you’ll get the twin benefits of steady income plus capital gains as the NAV goes up. So, buying some shares in quality ITs when markets are down can be a good strategy for those prepared to accept the extra risk involved.

Next page: What to seek

What to seek
However, be very selective. Choose an IT with a broadly based portfolio rather than one that focuses on a specific sector, such as energy.

Also, look for a trust that has a proven track record of maintaining steady distributions in both good markets and bad.

Some newer ITs guarantee principal at maturity (all these trusts have a limited life span), which offers comfort to nervous investors.

This security is achieved by holding part of the portfolio in a stripped bond. The maturity date could be 10 to 15 years off and, in the meantime, the market value of the units will fluctuate greatly.

Plus, a stripped bond ties up assets that may be used more productively elsewhere.

If ITs interest you, forget about guarantees and concentrate on quality.

Some tips:
Here are some tips for investing in these trusts.

• Select one with a track. Look at broadly based portfolios offered by such organizations as Mulvihill Capital Management, a leading Canadian company in this area. 
• Review the history of the trust’s NAV for stability. A trust with a record of high volatility should be viewed with suspicion.
• As a general rule, avoid new issues, even from reputable organizations. There have been several innovative approaches to income trusts recently, but great ideas on paper don’t always translate into profitability. Plus, new issues tend to carry hidden expenses, which compensate promoters rather than building assets for the trust.
• Avoid ITs that focus on a single industry or sector. As a general rule, they have been poor performers.

As with all parts of your portfolio, good diversification is the key to steady returns and capital preservation.

Gordon Pape’s new book, Secrets of Successful Investing, co-authored by Eric Kirzner of the University of Toronto, is published by Prentice Hall Canada.