Where do income trusts fit?

Q – I am wondering how and where income trust funds fit in an asset allocation model. They seem to me to be somewhere in between fixed income and equities. For example, if one invests 10% of one’s portfolio in income trusts, should one reduce both fixed income and equities by 5% each? – V.B.

A – You ask an excellent question, and one that does not have a simple answer. Income trusts are certainly not fixed-income securities, in the sense we traditionally understand the term. Bonds and GICs pay a fixed and guaranteed rate of return, hence “fixed income”. These trusts, which can take several forms, do not guarantee their distributions and in fact they can fluctuate significantly.

However, they are not true equities either, in that they do not represent ownership in a corporation. When you buy units in one of these securities, you’re actually buying a share of a trust or limited partnership in most cases. In that sense, they are somewhat akin to mutual funds.

In other words, these are hybrid securities that don’t conveniently fit into the traditional definitions.

One way to deal with this ito develop a more sophisticated asset allocation model, along the lines we have suggested in our Mutual Funds Update newsletter. As part of this, scrap the term “fixed income” and replace it simply with “income”. The securities you hold in that category will be those you have selected to generate cash flow for you.

Then sub-divide the income section into three categories, as follows:

Low-risk income. Include GICs, short-term bond funds, mortgage funds, mortgage-backed securities, short-term government bonds, CSBs, etc.

Medium-risk income: This would cover longer-term government bonds, investment grade corporate bonds, strip bonds, regular and long-term bond funds, etc.

High-risk income: Here is where you would slot in the income trusts, along with high-yield bonds, the mutual funds that specialize in them, and genuine dividend income funds.

This enables you clearly define the size of the total income component in your portfolio, and to allocate the degree of risk you are prepared to accept in that component. – G.P