Back to Normal for Income Investors

01/16/2008 12:00 am EST

Focus: GLOBAL

Gordon Pape

Editor and Publisher, The Income Investor and the Internet Wealth Builder

Gordon Pape, editor of The Income Investor, says recent outsized returns on income trusts and other instruments are gone, and investors should lower their expectations.

2007 will not go into the books as one of the better ones for income investors. But it marked a watershed in how we look at income securities and that’s not all bad.

For the first six years of this decade, we were living in a kind of cloud cuckoo land with regard to income-generating investments. Falling interest rates drove up bond prices, creating a situation in which low-risk government issues were producing both safe, steady income plus capital gains.

Meantime, the income trust phenomenon was gathering momentum. New issues began to appear almost weekly and prices soared as investors scrambled to get on board.

It couldn’t go on forever. [Canadian] Finance Minister Jim Flaherty took the brunt of the criticism for the sharp pull-back in the trust sector after he announced a tax on distributions on Halloween night 2006. Certainly, his actions were draconian and led to a sharp price correction which RBC Capital Markets recently estimated cost investors about $15 billion in net capital losses.

But the reality is that many trusts were overpriced at the time Mr. Flaherty made his statement. Plus the flood of new issues had diluted the overall quality of the sector dramatically. Something was bound to give, and the Finance Minister provided the final shove.

The 2007 numbers tell the story. As of the close of trading on Dec. 14, the S&P/TSX Income Trust index was down 3.8% year-to-date. That’s a lot less than most people expected at the start of the year but it’s a long way from the heady increases that investors enjoyed from 2000 to Oct. 31, 2006.

Over on the bond side, prices were negative for most of the year, only turning around when the extent of the subprime mortgage mess became apparent and the central banks began scrambling to reduce rates.

However, we need to keep all this in perspective. What has happened over the past 12 months is a return to normalcy for income investors. It is rare for a security to provide both high cash flow and capital gains for an extended period of time.

Usually, investors have to decide where their priorities lie. If income is the key, then the focus should be on choosing securities that offer a combination of yield and stability.

That does not mean income securities will never produce capital gains. But when that happens, it should be seen as a bonus. For several years, people investing in income trusts took for granted they would get both.

Now we’re back in the real world and I believe we’ll stay there [in the future]. Don’t expect the hefty capital gains of 2003-2006 [to continue]. There will still be the occasional big winner, but the name of the game here is cash flow and that’s where our emphasis will always be.

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