Income trusts beyond 2011

Canada is in the midst of a bull market in yield securities. Retail and institutional investors alike are clamouring for securities generating and paying a steady cash flow. The demographics of this country provide strong evidence of why the demand for yield has seemingly accelerated in recent years.

The 2006 Census conducted by Statistics Canada revealed that the number of Canadians aged 65 and over had increased by 11.5% since 2001. Fully 4.3 million people, or 13.7% of the population, are now in this age segment, which has traditionally invested heavily in yield securities. The Canadian workforce, citizens between the ages of 15 and 64, is also getting progressively older. The percentage of Canadians aged 55 to 64 grew by 28% since 2001, almost twice the 15% growth rate from 1996 to 2001.

Much of this growth was due to the leading edge of the baby boomers entering this age range. Statistics Canada notes that by 2016, 20% of the population could be aged 55 to 64, to go with the 13.7% who are already aged 65 and over. All these numbers boil down to the fact that Canadians are getting older.

This increased demand for income is coming at a time when the income options in this country are few, relatively unattractive and shrinking. Historically, retail investors have looked to GICs for safe, stable income. However, North American interest rates have been falling for most of the last decade. Table 1 demonstrates that when you factor in top Ontario marginal tax rates and historical levels of inflation, what you find is that GICs have delivered negative real, after-tax yields to investors each year for the last decade. Given where GIC yields are now (3% for a 5-year term, monthly pay option) and the outlook for growth, it stands to reason that negative real, after-tax GIC yields could persist for some time.

Over the last decade, bond yields have not fared much better. The Government of Canada 10-year bond yield fell from 6.4% in January 2000 to 3.3% in January 2010. Ironically, investors have shown signs of worry that this yield has crept up from a low of 2.7% in August to the current level of 3.2%. The truth is that bond yields remain near all-time lows and there appears to be few inflationary concerns to drive them up in the short to intermediate term.

Preferred equities often attract retail investor fund flows because of the favourable tax treatment of their dividend income. However, the size of the Canadian preferred equity market is relatively small and the list of issues is dominated by the banks, insurers and several other large-cap companies. As investors have piled into preferred equities, the yields have been driven steadily lower.

In June 2009, Brookfield Asset Management Inc. issued its Cumulative Class A Preference Shares, Series 22 and raised $300 million in capital. The securities yielded 7.0% at issue and reset every five years at a 445 basis point (bps) spread to the 5-year Government of Canada bond yield. Subsequently, in October 2010, Brookfield issued its Class A Preference Shares, Series 26 and raised $250 million in capital. These new securities yielded 4.5% at issue and reset every five years at a 231 bps spread to the 5-year Government of Canada bond yield. In the last 18 months, not only have interest rates fallen but spreads have contracted as well. The result is lower yields on preferred equity securities for investors.

That brings us to income trusts and Bill C-52. Income trusts are not unique to Canada and have popped up in the capital markets of other developed nations (e.g., Australia, United States). They are generally seen as a solution to the double taxation of dividends that equity investors endure in many markets. Businesses that generate significant free cash flow with few internal high ROE (return on equity) investment opportunities could efficiently distribute that cash flow to equity investors by structuring as an income trust.

The result was a large and growing sector of high-yielding equity securities that allowed investors to avoid the double taxation of dividends from traditional corporations. Predictably, the sector grew exponentially as demographics drove the demand for income securities higher, rates and competing yields fell, and conventional equity market returns stagnated.

Bill C-52 stipulates income trusts will begin to be taxed at the same rate as corporations, beginning in January 2011. In the interim, limits were placed on the amount by which income trusts could grow and still retain their favourable tax status. However, as we approach the deadline and income trusts begin to convert to corporations, the question on investors’ minds is, “What now?”

Real Estate Investment Trusts

Let’s start by tackling REITs (real estate investment trusts). For the most part, Bill C-52 left REITs untouched. Seniors’ housing and lodging REITs were specifically singled out as no longer qualifying as REITs. The thinking here is that too great a portion of their revenue is derived from active business operations (e.g., food and beverage sales, nursing care). When compared to the generally passive nature of the revenue streams the other REIT sectors generate, it is hard to argue this point.

However, when compared to the global standard for both sectors, it would appear we have taken a step back. The global trend appears to be towards including these sectors in the REIT universe, not excluding them.

Now it’s easy to look at seniors’ housing and lodging REITs and extrapolate that their businesses will be taxable at the corporate tax rate. This would be logical, intuitive and, in some cases, utterly incorrect. Investors must remember that statutory tax rates only apply to taxable income. To the extent that a seniors’ housing or lodging REIT does not generate taxable income, they are generally not impacted by the new tax regime.

Chartwell Seniors’ Housing REIT is an excellent example of this. Excluded from REIT status by Bill C-52, Chartwell technically became a business trust on November 1, 2006. Readers should recall that all income trusts were limited to 20% annual growth until 2011 to further constrain the growth of the sector. Chartwell violated this growth limitation almost immediately with the late 2006 to early 2007 closing of $850 million in acquisitions which grew the company by approximately 50%, as measured by suites.

However, Chartwell has historically paid most of its distributions as return of capital. In fact, in 2008 and 2009, Chartwell’s distributions were classified for tax purposes as 100% return of capital. As a result, Chartwell’s tax liability has been insignificant compared to the amount of distributions paid to unit holders. Management has stated several times in its financial reporting that it expects this situation to persist into the future.

For the rest of the REIT sectors, it is business as usual – almost. Many traditional REITs still carry on activities or own assets that generate active business income (e.g., mezzanine lending, strategic asset sales, extended stay properties). In some cases, this has required restructuring of both the operations (e.g., Canadian REIT, Calloway REIT) or the capital structure (e.g., InnVest, Northern Property REIT). Either way, traditional commercial REITs emerged largely unscathed from this process.

The other sectors of the income trust market were not so fortunate. Business, infrastructure and oil and gas royalty trusts were all subject to the growth limitation; beginning in 2011, they were to be subject to the same taxes as corporations. However, in some instances this actually improved the after-tax cash flow to investors.

Brookfield Real Estate Services Fund (BRESF) converted to a corporation on December 31, 2010. Their distribution declined from $1.40 per year to $1.10 per year and the differential is the anticipated tax impact. But looking more closely at the after-tax cash flows to a taxable investor, one finds that they will actually increase once the conversion and distribution cut take place. This is because in 2011, $1.10 will be paid as a dividend, whereas historically, the $1.40 distribution has been taxed as “other taxable income.” As the table demonstrates, assuming no change in the top Ontario marginal tax rates, once the dividend tax credit is taken into account, taxable investors should realize greater after-tax income from BRESF.

Given this fact, it’s no wonder that BRESF’s unit price was essentially unchanged on the news. Many other trusts fall into this category of generating higher after-tax yields to taxable investors, even after a distribution cut. It is generally those trusts that paid out most, if not all, of their distribution in the form of business income or interest income. The more favourable tax treatment of dividend income should result in a greater after-tax yield to investors even after the distribution cut.

Mixed results

Many income trusts have chosen to convert to corporations and reduce their distributions. The results have been mixed, with some trusts seeing a decline in their unit price while others have actually enjoyed gains. Pollard Banknote is a classic example of the former. On January 28, 2010, Pollard announced its conversion to a corporation and an approximate 79% cut to monthly distributions. Within two days, the stock was off approximately 25% and by August 2010, the stock was off approximately 50%.

Investors should not have been surprised by the distribution cut since Pollard had already cut distributions by 40% in 2009. A cursory examination of Pollard’s financial statements prior to the conversion announcements would have shown that Pollard’s payout ratio was above 100% in both 2008 and 2009, and the company operated with very high leverage (approximately 73% long-term debt to assets). This combination has always spelled doom for income trust distributions and Pollard was no exception.

On the other hand, Bonavista Energy Trust has traditionally employed a sustainable model of funding operations and distributions from operating cash flow and maintaining low leverage. The stock had been range-bound for most of 2010, but shortly after the September 15 distribution confirmation, the stock began to rally. It built momentum with the October 14 conversion announcement and the November 4 financial results. It was on November 4 that Bonavista announced it would be reducing its distribution by 25% upon conversion to a corporation. The unit price has since rallied over 7% despite the distribution reduction.

What accounts for the difference in reaction in these two names and others? Many income trusts that have cut their distributions have done so because they were carrying too much debt and were operating with an overly aggressive distribution policy. Put succinctly, a high payout ratio and high leverage magnify the volatility of a business’s operations and cash flows. This puts the distribution in jeopardy, which increases unit price volatility. These trusts have generally seen adverse reactions to their distribution cuts. Those trusts with more moderate leverage and a sustainable payout ratio have generally enjoyed more favourable market responses to their distribution cuts.

The outlook for this year

So, heading into 2011, what is an investor to do with their income trust holdings? I think investors are best served by critically examining why they owned income trusts in the first place. Investors should realize that if they owned a good-quality company on October 31, 2006, then they still owned a good-quality company on November 1, 2006. Regardless of organizational structure (i.e., trust or corporation), the fundamental business has not changed. All that has changed is the tax regime and, as we have demonstrated, this may not ultimately result in lower net cash flows to investors. Investors are counselled to seek professional advice on how to best minimize the tax implications of the new dividend income stream they are going to receive.

Investors should also realize that the same fundamentals of cash flow stability apply to trusts looking to convert to corporations. That is, those trusts with a sustainable business model (e.g., quality assets, low leverage and payout ratio) have the potential to absorb the new tax, in some cases without cutting distributions. Keyera Facilities Income Fund, Cineplex Galaxy Income Fund and Vermilion Energy Inc. are examples of income trusts from all three newly taxable sectors that will maintain their distribution levels upon conversion to a corporate structure and taxation regime. These and other high-quality income trusts will transition into high-yield equities that pay dividends to shareholders. If investors purchased these companies for the tax-efficient monthly income they generated in the past as income trusts, then these same investors should continue to benefit in the future; as corporations, these trusts should continue to generate strong dividend income. In an environment where the demand for yield is set to accelerate, investors should not ignore a viable and quality investment option that provides the desired income.

Finally, investors should realize that there is no “cookie cutter, one size fits all” approach to investing in income trusts going forward. Prior to Bill C-52, income trust investing required a close examination of financial statements to determine leverage and payout levels, and distribution sustainability. Heading into 2011, this has not changed. Nothing takes the place of informed due diligence and careful investigation of the merits of an investment opportunity.

Dennis Mitchell, MBA, CFA, Vice-President and Senior Portfolio Manager, Sentry Investments is the lead portfolio manager of Sentry REIT Fund and Sentry Infrastructure Fund.

Dennis Mitchell