A matter of trusts

In just a few years, income trusts have become the darlings of Canadian seniors – and a lot of Americans too!

At a time when interest rates hit their lowest levels since shortly after the Second World War, trusts emerged as a financial life preserver for people who had previously depended on guaranteed investment certificates (GICs) and government bonds to supplement their retirement income.

The years immediately following the turn of the millennium not only saw five-year GIC rates fall to below three per cent but also the deepest and most prolonged stock market dive since the Great Depression. If it hadn’t been for the trusts, which seniors favour for returns in the five to 12 per cent range, many older Canadians may have found it necessary to reduce spending and compromise their lifestyle.

If any further evidence is needed as to the importance of income trusts to seniors, just look at the firestorm that erupted after former Liberal Finance Minister Ralph Goodale indicated in September 2005 that his government might bring in a special tax to slow their growth.

CARP was inundated with angry pro-tests from members, andmy personal e-mail box overflowed with complaints. A few of the printable comments:

“This week I’m down more than $30,000 because of what was done in Ottawa. They couldn’t run a lemonade stand!” – W.R.M.

“The Liberals have no clue what it is they are doing.” – E.S.

“They’re playing Russian roulette with the life savings of thousands of Canadian retirees and seniors … We don’t deserve this.” – R.C.

We all know how the story turned out. Just days before the collapse of his government and the calling of an election, Mr. Goodale abandoned the trust taxation idea and announced the dividend tax credit would be increased instead so as to “level the playing field” between corporations and trusts. The Conservatives followed through with this plan in their first budget.

With trusts now apparently safe from government meddling, investors are flocking back, and we’ve seen several major new issues, including mutual fund giant CI Financial and Bell Aliant Regional Communications, which combines rural telephone services in Ontario and Quebec with Bell’s land lines in Atlantic Canada.

But despite all the publicity, it appears that many people still don’t understand what trusts are or how to choose them. So here are the five most important things you need to know about income trusts.

1. What they are
Essentially, trusts are simply businesses with a different type of legal structure. Most businesses in Canada have traditionally been set up as corporations and are taxed on that basis. Dividends are paid to shareholders out of after-tax profits.

By structuring itself as a trust, a business can avoid paying corporate tax entirely. Instead, it pays out its profits (or, more technically, its distributable cash flow) directly to its shareholders who then pay tax at their personal rate.

A trust may also pass along tax credits directly to investors who, in turn, can use them to reduce their own tax liability. Real estate investment trusts (REITs) are especially useful in this regard.

Thanks to recent legislation, trust investors now enjoy the same limited liability privileges as shareholders of corporations. You will not be held personally responsible if a trust runs into major financial problems, although the value of your investment will almost certainly go down.

2. How they work
Trusts are designed to pay a steady income stream, usually monthly, at a rate of return well in excess of what you might expect from a government bond or GIC. (Average dividends on blue-chip stocks are in the three per cent range, or five per cent after tax.) The ratio of cash payments to the price of the shares is known as the yield, and at the time of writing, the usual range was five to 12 per cent, although a few trusts were higher.

The money is paid from distributable cash flow, which does not equate to pro-fits, a fact that confuses many people. Profit, which accountants refer to as net earnings, is the amount left after all deductions, including non-cash amounts such as depreciation, have been made. There is no universally accepted definition of distributable cash flow but, in broad terms, it’s the amount left after deducting operating expenses from revenue.

The percentage of this figure that is actually paid to investors is known as the “payout ratio.” This is an important number in assessing the strength of an income trust, and we’ll come back to it.

3. How you’re taxed
The taxation of trust payments can seem confusing because it can consist of four different types of income. The reporting slip you receive from the trust at tax time will break them out separately. They may include any or all of the following:

Interest. These payments will show up as “other income” on your reporting slip. The money is taxed at your full rate.

Dividends. These will be eligible for the federal dividend tax credit if the payment is received outside a registered plan.

Capital gains. You’re not likely to receive capital gains payments directly from a trust, but you may find that some of the money from an income trust fund falls into this category.

Return of capital (ROC). This is the one that tends to mystify many people. The term makes it sound like you’re simply getting back your own money, but that may not be the case. Return of capital can be created by the use of tax credits to shelter part of a trust’s payments. Any money received as ROC is tax-deferred – you do not have to declare it on your return. However, you need to keep track of something called the “adjusted cost base” (ACB). This involves deducting the value of all ROC payments from the original price of the shares. The ACB is used to determine your taxable capital gain when you sell.

Taxation of income trusts is somewhat complex. If you do your own tax returns and want to keep things simple, you may decide investing in trusts is not for you.

4. The risks
By now, most people realize income trusts are not a higher-paying version of blue-chip corporate bonds. They’re stocks and are subject to the same market risk as any other business. We’ve seen major flame-outs this year, with the widely held Superior Plus Income Fund the most traumatic (one of my newsletter readers wrote that he was “devastated” by what happened).

If you didn’t follow the Superior Plus debacle, here’s what happened. In November 2005, the trust released third-quarter results for that year and announced a 2.5 per cent increase in its monthly payout. Distribution increases are regarded as a sign of financial health, and Superior’s management contributed to that impression by expressing confidence in the future in their comments.

Four months later, on March 8, the trust suddenly changed course. Management reported a marked deterioration in distributable cash flow per unit and said that the monthly distribution would be cut by about 10 per cent “due to challenging business conditions.”

Then came the crusher. On April 24, less than two months after the first payout cut, Superior announced it would slash the monthly payment by another 30 per cent and launched a “strategic review to maximize unitholder value.” Predictably, the share price fell dramatically. Investors were shocked. Perhaps more important, so was Dominion Bond Rating Service (DBRS), which after the first cut had reiterated its STA-3 (middle) rating on the trust. Even the experts had been blindsided!

Superior Plus is a prime example of how a diversified business trust can run into trouble, but there are other risks associated with these securities. Many trusts are based on resources, especially oil and gas. Payments from these are closely tied to movements in commodity prices. When oil and gas prices are rising, cash flows increase, and trusts can increase payouts. But when prices decline, distribution cuts may follow. We saw an example of this in June when Calgary-based PrimeWest Energy Trust announced a 16.7 per cent distribution cut, blaming it on weak natural gas prices.

Rising interest rates can also have a negative effect on income trust prices. REITs are generally believed to be the most vulnerable to rate increases, and in fact, the sector was harder hit than the broad income trust index in the first half of this year.

The bottom line is there are no guarantees with income trusts. Payments can be changed at any time at the discretion of a board of directors, and the market value of your investments will fluctuate. So keep your eyes open and choose carefully.

5. Choosing winners
Since trusts are not a guaranteed investment, how can you mitigate your risk and still benefit from higher returns than you would receive from a bond or GIC? Here are some guidelines that should enable you to build a sound trust portfolio while keeping risk within manageable limits.

Diversify. The old adage of not putting all your eggs in one basket applies here in spades. Not only should you spread your money across several trusts but you must avoid becoming too heavily overweighted in one sector. For example, if most of your trusts are in the energy business, you open yourself to extreme volatility when oil and gas prices make big moves.

If you don’t have enough money to diversify properly, consider a fund instead. There are about 50 mutual funds that specialize in income trusts and many others in the Canadian Income Balanced category that have a large trust component. You can also buy index-linked exchange-traded funds on the TSX, such as the iShares CDN Income Trust Sector Index Fund, and actively managed closed-end funds from companies like Citadel and EnerVest.

Look at the distribution history. Despite the Superior Plus experience, a trust that has a history of regular distribution increases is usually a good bet. It’s a sign that management has been successful in increasing cash flow and keeping costs under control for a long time. A classic example is Rio Can, Canada’s largest REIT, which increased its distributions every year over the decade from 1995 to 2005.

Check the payout ratio. As I explained earlier, the payout ratio represents the percentage of money actually paid to unit-holders compared to the distributable cash flow. It’s a key number in assessing the solidity of a trust’s finances and one of the first figures that analysts look at. It is calculated by dividing the amount actually paid out by the total distributable cash. So if a trust reports distributable cash of $1 million and pays out $900,000 in the same quarter, the payout ratio is 90 per cent.

A payout ratio of more than 95 per cent is cause for concern. It means the trust is skating close to the edge, and any reversal of fortunes could result in a distribution cut. If the ratio is more than 100 per cent, be especially wary. It means a trust is paying out more cash than it is left with after expenses and that can’t go on forever.

Some trusts keep their payout ratios deliberately low in order to have more money available for exploration, research, acquisitions or development. Peyto Energy Trust is an example. It had a payout ratio of only 44 per cent in the first quarter of this year.

As a general rule, avoid trusts with payout ratios in excess of 95 per cent. Anything under 90 per cent is very good.

Consider the yield. The yield of an income trust is a clear indicator of the degree of risk the market attaches to it. As a general rule, the higher the yield, the greater the risk. If you decide to buy a trust with a 15 per cent yield, chances are high that some bad news will drop on your head in the ensuing months. Conversely, a trust with a yield in the five to six per cent range is seen as being very stable with little risk of a distribution cut.

Review the stability rating. Two Canadian-based credit rating agencies cover the income trust sector: Standard & Poor’s Canada and DBRS. Both provide what are called “stability ratings” for trusts. Both use a seven-point scale, with one being the best and seven the lowest.

The ratings, based on a trust’s financial ability to sustain and increase distributions, are available to the general public on both sites along with background reports. However, only a small percentage of all listed trusts are rated. That’s because organizations must apply and pay for a rating. Most choose not to do so.

Also, the ratings are not guarantees. Use stability ratings as a reference tool, but remember that even they can be wrong. DBRS describes the STA-3 rating given Superior Plus as indicative of “good distributions per unit stability and sustainability.” No hint there the trust would cut its distributions twice in the same year.

Be wary of IPOs. Now that the threat of federal government taxation has been removed, we can expect many new trust issues to come to market. These are called “initial public offerings,” or IPOs for short. Be very cautious about investing in them.

Some trust IPOs in recent years have attracted tremendous investor interest, such as those of Aeroplan, Yellow Pages and Air Canada’s Jazz regional carrier. Often, the initial hype will provide enough momentum to drive up the price after the shares begin trading on the TSX, but that’s not always the case.

Plus, for every blue-chip issue that comes to market, there are three mediocre ones and at least one dog. Perhaps the worst IPO in recent years was that of FMF Capital, a Michigan-based mortgage company that specializes in high-risk loans. It went public on the TSX in June 2005 at an IPO price of $10. That was the high point. The shares began to decline in value almost immediately and plummeted in December after the company announced it had run into serious financial problems. By June 2006, they were trading for 30 cents.

So stay away from IPOs unless it’s a name brand that you know and respect. The risk of being burned is too high.

In the end, it all comes down to the standard rules of investing: do your homework, get expert financial advice, diversify and don’t be greedy. Always remember the main goal of a good income trust is to provide steady and dependable cash flow. Keep your focus on that, and you should do just fine.