 In
recent years, a creative new form of financial instrument has become all
the rage in Canada (it has not caught on, to my understanding, in other
countries, though the US does have a similar more narrowly-defined
security called a Real Estate Investment Trust). It's call the Income Trust (or Income Fund), and it's a form of high-yielding equity,
filling the 'gap' between today's overpriced, low-yielding common
stocks and moribund, equally low-yielding bonds. They're so popular
that when a Canadian oil company announced today it would convert all
its shares to Income Trust units, the stock jumped 15% on the news.
There are several hundred Income Trusts traded on Canadian stock
exchanges, and Income Trusts now constitute the majority of new
Canadian initial public offerings.
I am not an investment
advisor and the information below is what I have gleaned from some
confusing and sometimes contradictory information on a variety of
Canadian websites.
The tricky part about Income Trusts is the
huge variation in terms and conditions, but let's start by looking at
what just about all Income Trusts have in common:
- They are
issued at a price to yield generally 7-10% before tax; however, this
yield depends on the Income Trust's cash flow and is not guaranteed
- They
are secured by assets that have a long life (real estate, pipelines
etc.) and which yield a significant realtively steady annual cash flow
(from rents, royalties etc.)
- To the extent these assets
depreciate, that proportion of the annual trust income is treated by
the unit-holder as a return on capital, subject to a lower tax rate
- Because
all the 'income' of the Income Trust is paid out as an 'expense' to
unit-holders, the Income Trust has no 'net income' and hence (under current Canadian tax law anyway) pays no corporate tax
- As
long as interest rates remain low, Income Trusts are attractive at
7-10% yield rates, but if interest rates suddenly spike, the price of
Income Trusts should be expected to plunge to the point their
(un-guaranteed) yield exceeds the yield of (guaranteed) bonds, T-bills
and investment certificates
Now some of the differences:
- Since
the assets of the Income Trust can be seen as 'wasting' rather than
appreciating, some Income Trusts have a guaranteed buy-back price equal
to the initial issue price; this would protect the investor in the case
of an interest rate spike, but it too has some tax consequences -- a
portion of the buy-back price, when you receive it, is taxed as a
capital gain
- Some Income Trusts are much riskier and carry
yields as high as 20%; they are generally fixed-life trusts and when
the assets are fully depreciated or depleted, you just have to hope the
projections were right and you've already recouped your investment
- There is now a second type of Income Trust called financial Income
Trusts that are actually a completely different type of financial
instrument; they buy a basket of stocks in other companies, usually
those that are quite price-volatile, and sell call options on them (the
call option allows the buyer to limit the amount of loss -- and gain --
on these volatile stocks, to moderate the risk); the income from the
call options provides a steady cash flow that is paid out to the Income
Trust's unit-holders just as in any other Income Trust, though the tax
consequences can be quite complicated -- but the advantage is that this
type of Income Trust will rise rather than fall when interest rates jump, and it is only vulnerable to periods of significant stability
in the stock market (which lower the value of call options and hence
squeeze the Income Trust's cash flow; so some investors are buying a
mix of both types of Income Trust, hedging one against the other
So
if you're living on a fixed income, you may be drawn to the 7-10%
return that Income Trusts offer, even though that return is not
guaranteed (the issuer's reputation is at stake, and some investors
figure that if the economy gets bad enough that companies have to
sacrifice their reputation by reducing their Income Trust's yield,
other equities and bonds will probably be in the tank as well). And
some Income Trusts do guarantee to pay you back your 'principal'
investment, so if you have these you can cash out and reinvest in high
interest T-bills when the next stagflation/depression hits.
But
there are other risks besides the lack of guaranteed yield, If the
assets are in real estate or some other industry where the bubble
bursts, the 'steady cash flow' may suddenly dry up. The current tax
treatment of these investments is under review in Canada. And some
Income Trusts don't yet have the limited liability protection of common
shares (though that is coming).
As with any investment, you have to read the fine print to understand all the terms and conditions. As they say
"the projected life of distributions and the sustainability of
distribution levels tend to vary with the nature of the business
underlying the income trust". In the meantime, a lot of people
desperate for a reasonable return on retirement savings and terrified
by overpriced stock markets and overheated real estate markets are
betting heavily on Income Trusts, sometimes perhaps with insufficient information
to do so wisely. But in the short run, this is the market's way of
filling an urgent need in a low-interest-rate, high P/E, volatile
financial market.
The real mystery to me is why Income Trusts haven't caught on in other countries.
(Full
Disclosure Statement: I am a relative of the owners of Pollard
Banknote, a company in Winnipeg that has just successfully completed an
Income Trust public offering. I have however no personal financial
interest in the company.) |
MADE IN CANADA
trust your
instincts 
