The income trusts dilemma
It appears as though Canadian interest rates are likely to remain at current levels at least through the rest of the winter, despite this month’s encouraging jobs report. That’s good news for most of us, but bad news if you are looking for income from your securities.
GIC rates continue to be at unattractively low levels. Royal Bank, for example, was offering 2.6 per cent at the start of 2005 on five-year non-redeemable GICs. You’ll do better with a five-year Canada bond, which was being quoted on the CBID Markets website on Jan. 7 as having a 3.75 per cent yield to maturity. But even that isn’t going to excite older investors who are looking at mandatory RRIF withdrawals of 7 per cent+ this year and may have no choice but to dip into capital.
It’s no wonder, then, that the income trust market continued to stay hot in 2004, rallying strongly after a correction in the spring to finish with a 15.4 per cent gain. But the result of the rising share prices was to drive down yields, in some cases dramatically.
The soaring price of trusts has many advisors worried and reluctant to add more to clients’ portfolios.
“Thesare not bonds!” warned one broker who has long been a fan of income trusts. “They’re equities and when you see yields down that low you are not being paid for the risk involved.”
Impact on retired Canadians
He is concerned that we could see a sell-off in the sector in 2005 that could snowball into something quite serious. This would happen if investors in income trusts mutual funds decided to bail out as the market began to drop. The redemptions would force the fund managers, who normally maintain low cash positions, to sell into the falling market, thereby accelerating the decline.
The end result would not be pretty and would have the greatest impact on those least able to withstand a loss in their capital: retired Canadians.
While I do not foresee a meltdown, I share these concerns. I think income trusts as a group (there are some exceptions) have become too expensive and are headed towards a correction of 10 per cent to 15 per cent. The only thing that is unclear is the timing.
But if you need the income that the trusts generate, what are you supposed to do? If you sell now, you could wait for several months before the decline takes place. In the meantime, your cash flow would be cut off.
Unfortunately, if you choose to hold and there is a sharp drop in the sector you won’t be able to escaped unscathed. However, there are some ways to mitigate the downside risk. Here are three ideas.
1. Focus on trusts that have shown an ability to increase distributions. Rising payouts is the best protection you can have against a drop in the share price.
2. Choose mutual funds that invest in a balanced income portfolio. The pure income trust funds will be the most vulnerable in a sector downturn. Those that hold a diversified portfolio that includes trusts, bonds, mortgage-backed securities, preferred shares, and high-yielding common stocks will hold their ground better. The term “monthly income” in a fund’s name often denotes this type of approach but ask about the portfolio composition before you buy.
3. If you insist on a pure income trusts fund, buy a closed-end fund that trades on the TSX. The reason is that closed-end fund managers do not have to worry about redemptions if investors sell, so they are not obliged to liquidate assets in a declining market. A fund run by a conservative manager like Paul Bloom, who builds cash reserves when markets are overheated, is a good choice. He oversees various Citadel funds, such as the Citadel Diversified Income Trust (CTD.UN), which had a 16 per cent cash position in late December.
This is a time to be very cautious and selective in your income trust purchases. And don’t be afraid to take some profits if the price of a trust you own seems grossly out of line.