Understanding income trusts

The number one challenge that older investors face in today’s markets is deciding how much risk they are prepared to accept in exchange for increased income from their retirement portfolios.

The risk/reward equation has always been a prime factor in stock selection. But it appears to have been a lesser consideration for many people in their evaluation of income trusts, the investment phenomenon that has taken the Canadian markets by storm in the past few years.

One of the reasons for this may be that investment trusts are a unique, home-grown product, made possible by our tax laws. There is nothing quite like them in the United States. Normally, we take our lead on evaluating securities from Wall Street, but New York has little to teach us when it comes to assessing the merits of a particular income trust. We’re pretty much on our own.

In my view, the biggest mistake investors make in assessing income trusts is to base the decision on yield. Although we’ve become more sophisticated about these securities in recent years, there is still a tendency to believe that more is better when it comes to payouts. That’s not necessarily thease. Let’s look at a couple of examples.

We’ll begin with the Sun Gro Horticulture Income Fund, which went public in March 2002. It looked like a nice, stable, low-risk business, selling peat moss to greenhouses and professional growers across North America. The company had been operating since 1929 and boasted a 30-year supply reserve from peat bogs across Canada. The prospectus claimed a “stable cash flow” and projected a yield of 11.75 per cent, based on a $10 per unit cost. Not many people can get very excited about peat moss, but in this case investors were intrigued enough to snap up some $220 million worth of shares.

Everything started out just fine. The trust made its initial distribution of 9.79c per unit in August 2002, and continued monthly payments at that rate until June of this year. However, by late winter there were signs of problems emerging. In March, the company issued a first quarter report and outlook in which it stated: “The first 12 months of the Fund’s performance generated a level of cash flow that neither management nor the Board of Directors considers adequate.” The report went on to say that a new budget had been adopted but warned that “factors may develop during the year that have a material impact on the ability of Sun Gro to achieve the budget.”

These ominous words triggered a precipitous drop in the share price but some money managers weren’t concerned. Leslie Lundquist, the highly-respected manager of the Bissett Income Fund, told a conference call that she felt the problems at Sun Gro were only temporary.

Then the other shoe dropped. In June, the trust cut its distribution to 8.44c, stating that the fund’s trustees had decided that the operations of the business could not support payments at the level forecast in the prospectus that had been issued just over a year before. Worse, it was announced that accounting irregularities had been uncovered relating to inventories that forced a restatement of the trust’s financial statements from the time of its inception.

Recent, the units were trading at $8.20, down $1.80 from their issue price at a time when most income trusts valuations have been rising. The yield was up to 12.3 per cent, reflecting the increased risk that this supposedly stable business is now perceived to carry.

Compare that story to what’s happened with Yellow Pages Income Fund since its launch. I recommended the units in the Internet Wealth Builder newsletter at the IPO price of $10, with a yield of 8.25 per cent. Recently, they were trading at $11.08, with a yield reduced to 7.45 per cent. Obviously, investors see this as a very stable security and they are willing to accept a much lower return as a result. Let’s hope that turns out to be the case.

So what can we learn from this? The most basic lesson is that there is a direct correlation between yield and risk. The higher the yield on an income trust at any given time, the greater the chance that it will not be able to sustain its current level of payments. The market is effectively factoring the probability of a distribution cut into the share price. Investors are demanding, and receiving, greater compensation for the risk they are incurring. That’s why Yellow Pages was recently yielding 7.45 per cent while Pengrowth Energy Trust was yielding 14.4 per cent.

The moral is that if income stability is important to you, focus on trusts that are currently yielding less than 8 per cent. The market is telling you that they are the ones that are best positioned to maintain their distributions at existing or rising levels.

If you opt for a trust with a higher yield, understand that you have a greater chance of facing a distribution cut down the road. If you are prepared to accept that risk, go ahead. Just be aware that it can happen and the higher the yield, the more likely it is that the cut will come sooner rather than later. (Sept. 2003)Adapted from an article that originally appeared in the Internet Wealth Builder, a weekly electronic newsletter the provides top-quality, conservative investment advice. To take advantage of a three-month trial subscription available to 50plus.com users for just $24.97 plus tax, go to http://www.buildingwealth.ca/promotion/50plusproducts.htm