Hunt is on for quality trusts

(November 2006) In the days following Finance Minister Jim Flaherty’s announcement that income trusts would face similar taxation levels as corporations, the markets reacted with their characteristic good sense: a mass sell-off of the affected asset, followed by an immediate — albeit partial — rebound in prices.

Having time to digest the news, market analysts are now offering their opinion on what it all means and how investors should best react to the impending changes. One question that has long haunted the trust market remains: How do you value these things?

One of the peculiarities of the income trust frenzy was that the market was — at least in its early days — driven by retail investors seeking yield for their portfolio. While many institutional managers hummed and hawed over theoretical risks such as unlimited liability, Main Street investors piled in, giving them a far larger stake in the sector than they had among common equities. Trusts are still widely held by individual investors, many of whom have been left scratching their heads.

John Nicola, founder of Nicola Wealth Management, says trusts had become overpriced, and as a result he has already cut his clients’ exposure to them. When the announcement hit on Halloween, his clients held between 4% and 10% in trusts, with an average portfolio exposure of 6% — so his clients were rather well insulated from the 14% decline in trusts on November 1.

Nicola is recommending his clients consider buying more of the high quality income trusts for taxable accounts. For registered account-holders he suggests not making any changes right away, since the new rules don’t kick in for until 2011.

Despite much hyperbole in the press in the days following the announcement, Nicola says it does not spell the end of income trust investing as we know it.

“It is not even the end of high-yield assets that income-starved Canadian investors have come to expect,” he says. “Overall, I feel the long-term impact will be slight and even this week’s significant correction is minor when compared to the overall returns generated by income trusts over the last 5-6 years, as we shall see.”

He says the dividend tax credits make companies with high dividend growth more attractive than trusts.

“This past week has been a good reminder of why we need to be diversified,” says John Nicola. “It is also important to remember that in order to be able to acquire assets at good prices, we need to have times when they are on sale or available at a discount. Not all trusts are cheap by any stretch of the imagination, but some good quality opportunities do exist and we need to be shopping.”

Richardson Partners Financial issued a report — penned by private client strategist Craig D. Basinger and senior vice-president & CIO Clancy T. Ethans — which predicts income trusts will have declined by an average of 15% as the dust settles over the next few weeks.

“Lower valuations will likely lead to consolidation of income trusts,” the Richardson report says. “Whether it is trusts buying one another, private equity cherry picking trusts for their cash flow or parent companies buying back the very trusts they sold to the public a few years back, lower valuations will lead to fewer trusts than there are today.”

This trend has already claimed its first victim, as Macquarie Infrastructure Partners snapped up port-operator, Halterm Income Fund.

Dan Hallett, president of Dan Hallett and Associates, points out that investors will need to analyze the structure of their distributions.

“The price decline of a trust should be greater for trusts with a higher percentage of fully taxable distributions. This makes sense given that the treatment of return-of-capital distributions will not be changed,” he wrote in a research note. “At the high end, trusts with 100% taxable distributions can expect to see a tax hit of 22%. At the other extreme, trust with 100% RoC distributions should see no impact whatsoever from the tax change.”

Hallett expects the trust universe to contract somewhat, as those companies that converted solely for the valuation increase will revert to their old corporate structure, but not likely before the end of the four-year tax holiday. This trend is also starting to take shape, with CI Financial announcing it will revert to a corporation on January 1, 2011.

Another question mark hangs over mutual funds which invest solely in income trusts. Many analysts have long said that trusts are nothing more than high-yielding equities, and Hallett says with the new tax structure, the line between equities and trusts is further blurred.

He predicts trust-dedicated mutual funds could merge be merged with diversified income funds in the same family, or could see their own mandates broadened to allow investments outside of the trust universe.

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

(11/10/06)

Steven Lamb