Future of income trusts still uncertain

(May 2008) When Jim Flaherty announced in October 2006 that income trusts would be taxed in 2011, many investors thought the market was as good as dead. But that hasn’t been the case. In fact, the income trust sector has not only rebounded, its benchmark is outperforming the TSX Composite Index by about 7%.

Leslie Lundquist, vice-president and portfolio manager with Bissett Investment Management, says the income trust sector is actually better off now than it was before Flaherty’s Halloween announcement. “We have seen many of the trusts do very well,” she says. “And you can see that in their distribution increases.”

She points to her own fund, the Bissett Income Fund, as proof that things have improved. The top 10 companies in her holdings have increased their dividends, some multiple times, since Flaherty’s announcement. Added to that, a number of trusts in the market have lower valuations than they did pre-October 2006, and it’s clear there are some good buying opportunities.

“Trusts will continue to do well, they’ll continue to grow their distribution, and prices are lower,” says Lundquist. “I’d argue it’s a better environment now because prices are off, and companies are actually doing well.”

The trouble, however, is that no one’s sure what the sector will look like come 2011. Lundquist has talked to high-ranking executives at a number of income trusts, and many of them are still unsure what the fine details will be, so they haven’t been able to properly plan for the future. “Businesses have looked at it,” he says. “But what a lot are saying is that we have no reason to convert into a corporation at this time, and when we get legislation, we’ll assess more.”

She says some trusts have switched to a corporation already, but she “doesn’t know how they’re doing it without the full information.”

When these income trusts eventually convert to a corporation, the hope is that nothing will change. Distributions will continue to be paid and keep growing, so investors can remain happy with their income-generating holdings. But so far, nearly all the trusts that have converted have cut their distributions, and the unit price has dropped. Not a good sign for investors who have so far stayed the course.

Lundquist says investors shouldn’t be worse off on an after-tax basis if companies cut their distributions, but pre-tax, clients will lose about a third of their cash flow. She says most clients don’t look at after-tax, so if the trend continues, and companies slash their payouts, there could be problems for everyone down the road.

But Lundquist doesn’t think this will happen. She says Yellow Pages Income Fund has pledged not to cut its distribution, she doesn’t think Davis & Henderson will, and she expects a number of other strong companies to keep their payments coming.

She knows, though, the difficulty income trusts face in the eyes of investors. “I look at it and say, why would you want to invest in income trusts?” she says. “For investors today, I wouldn’t want to hold on to a trust that would cut its distribution because I would expect the price to go down. What we’re doing in my fund is holding on to ones that we think won’t cut distributions.”

In all this uncertainty, Lundquist says it’s the strong companies that people should look at. Ones with good business models, growth potential and top-notch talent not only will survive the trust conversion but will remain strong in the long run.

If anything good came out of the October announcement, it’s that many of the weaker trusts “faded into the night,” as Lundquist says. She points out that before Halloween two years ago, many trusts would have big “blowouts,” but that hasn’t happened much since Flaherty’s income trust bombshell. “A lot of trusts were shaken out before the announcement,” she says. “After that, the weaker companies either merged into something else, got taken out or moved into a corporation early.” That means the stronger companies, the ones able to weather the changes in 2011, are the trusts that are still standing.

Despite some of the more positive news coming from the income trust sector, Lundquist admits that many advisors don’t have much of an incentive to get their clients to invest in the trust market. She says most clients want to talk about what’s in the news, such as energy, oil and gas and potash, and not the “boring things.”

She says advisors don’t have any real incentive to push the trust market, especially because no one knows what will happen come 2011. “Why try to convince someone that they should, for their own financial health, buy an income trust when the client is perfectly happy getting an order to buy the hot stock?” she asks. “Why try and fight with them on it when you can place an order by giving them what they want?”

Because it’s easier to make a commission on what clients want than to change their minds, an advisor would have to be quite passionate about the income trust sector to really make a case for it. “Those are really hard conversations to have,” says Lundquist. “The ones having them, though, are the ones whose clients need the income.”

While no one knows for sure what will happen when trusts have to convert, Lundquist is confident that the companies in the income trust market will survive. She points to EnCana’s recent decision to split the business into two as an example of how markets might react when trusts switch to corporations.

“If you think about October 31, what was really announced? Income trusts will have to restructure, they’ll have a higher tax bill, and they will have to change their name,” she explains. “EnCana [which isn’t an income trust] made a significant announcement out of the blue. It said it was going to change its structure, have a higher tax bill, and it’s going to change its name. And what happened? Did all heck break loose? No, it didn’t. Investors realized it’s the same assets, the same people and, in a sense, the same strategy. Ultimately, it’s the same company, and it will continue to do what it’s always done.”

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com

(05/29/08)

Bryan Borzykowski