Quality trusts offer downside protection

(August 2007) It has been an unusually rough summer on the capital markets, which may be fine for younger investors with longer time horizons, but for those nearing retirement — or already there — volatility is the last thing they need.

For investors who want downside protection and potential growth, it may be time for a second look at last year’s dog: income trusts.

“There’s a wide spectrum of quality in the income trust market, just as there is in the equity market, but it is very possible to put together a very high-quality, relatively conservative portfolio for investors looking for income,” says Michele Robitaille, senior portfolio manager at Guardian Capital and co-manager of the GGOF Monthly High Income Fund.

“Income trusts do remain one of the best and most tax-efficient income vehicles available in the Canadian capital markets today.”

She points to the shrinking list of preferred shares on the market, with valuations for the remaining few crushing their yield. The 10-year Canada bond is still delivering only about 4.4%, while the high-yield bond offers little stability.

Trusts took their own pounding last year, following the October 31 announcement by Finance Minister Jim Flaherty that distributable cash would be taxed starting in 2011.

Robitaille says the November 2006 sell-off was rational, as prices on trusts quickly settled out at a level that accurately reflected the cost of future taxation. Since then, trusts and common equities have moved pretty much in tandem.

“The last couple of months they’ve been hit pretty hard,” she says. Year to date, trusts have posted a capital loss of 4.2%, but factoring in their distributions, the total return has been a gain of 1%.

“The up-front yield on trusts is so strong on trusts. If you look at the yield on the S&P trust index today, it’s about 8.5%,” she says. “That provides some downside protection in a market where you are getting some pressure on unit prices.”

Despite this downside protection, Robitaille says there has been little evidence that investors are taking a second look at trusts. Judging by mutual fund flows, which make up “a good chunk” of the overall trusts market, there has been a continued sell-off from trust-focused funds since November 2006, but this summer’s volatility may be stemming the tide.

“The net outflows out of dividend and income funds have been declining pretty dramatically over the past few months,” she says. “They’re pretty close to flat and that’s due to people looking for more conservative, defensive names. That’s a trend that I would expect to continue with this current market volatility.”

Still, the recent credit crunch that initiated in the U.S. has had a negative impact on the trust sector, as the ability to fund acquisitions on the cheap evaporated. Robitaille expects that deals will become few and far between.

“There was a pretty significant takeover premium that was built into the business trust names and the REITs,” she says. “You’re seeing that takeover premium come out of the unit prices.”

Trusts may still be facing taxation in 2011, but Robitaille says that leaves three years of high-yielding, tax-efficient distributions. Even when the new tax regime is imposed, many of the underlying companies will remain not only viable, but attractive.

“There’s still a little bit of uncertainty regarding the rules of implementation but for most of the trusts, especially the high-quality ones, you have to look at the underlying business,” she says. “Whether they are in a trust structure or a corporate structure becomes largely irrelevant. Most of these companies, come 2011, will convert back into corporations, in our view.”

Even after conversion, she expects that most of these businesses will remain high-yielding dividend stocks. With the tax code favouring dividend income, the proceeds for investors should remain attractive on an after-tax basis.

She says the GGOF Monthly High Income Fund is currently invested entirely in income trusts, and that she does not expect that allocation to change for the next two years. But the fund’s mandate allows its managers broad latitude to invest in any income vehicle they deem appropriate, so a mandate change will not be needed.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(08/27/07)

Steven Lamb