Trust of Trusts

02/11/2005 12:00 am EST


Gordon Pape

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

Gordon Pape has written more than 40 books on investing, and publishes four newsletters. A Canadian, Gordon is also a leading expert in the increasingly popular field of Canadian high income trusts. Here, he looks at a more conservative, "trust of trusts."

"Income trusts are similar to real estate investment trusts, but with some unique characteristics. They are structured as a trust, not a corporation. The difference is significant, as under Canadian law, a trust must pay out its profits to shareholders at least once a year. Payments are made monthly in most cases, so steady cash flow is an important advantage. It is important to remember that the payments are not guaranteed. These are not bonds and if a trust runs into financial problems it may reduce or even suspend distributions. That’s bad news. As a general rule, these trusts offer only modest growth potential. Also as a general rule, the higher the cash yield from the trust, the greater the risk.

"Although we expect more modest gains from income trusts this year than last (when several of our recommended trusts had total returns above 100%), we still think three factors will help this market. First, Canadian interest rates are not likely to go up for a while, as inflation is not a serious threat. The second factor is that the fear of limited liability to shareholders is now gone and pension plans are now poised to buy more aggressively. Finally, Standard & Poor's has announced that income trusts will be included in the benchmark S&P Toronto composite index by mid-year, which means that index funds would have to buy them in order to track the index properly. So the bottom line is that while I believe the sector is relatively expensive, I don’t expect to see a sharp correction.

"But since the market has become expensive, I suggest that you not try to pick individual trusts. Rather, my advice is to let the pros pick the trusts for you. I suggest the  Lawrence Payout Ratio Trust (CA:LPR.UN  Toronto), a closed-end fund that invests in a portfolio of 40 equally weighted income trusts with the lowest cash payout ratios from various sectors. The payout ratio is very important when it comes to selecting an income trust. It’s the percentage of a trust’s cash flow that is distributed in a particular year. The idea behind this trust is that the lower the payout ratio, the greater the chance that a trust will be able to maintain its current distribution levels and increase them down the road.

"The history of the income trust sector has clearly shown that when a trust is forced to cut distributions, its share price gets clobbered, sometimes disproportionately. So the theory is that the structure behind this fund will greatly reduce that possibility. Some of the other criteria for inclusion in this fund are a market cap of at least $200 million, a listing of at least a year on the Toronto stock exchange, and no reductions or suspension in payments for at least two years.

"This fund is brand new, so we don’t have a history for it. Payments will be made monthly. The first payment of 8.75 cents per unit will be made on February 14. I don’t expect that subsequent payments will be that high, because this payment covers a six-week period. However, I think an average monthly payout of 6 cents a unit is quite feasible. Based on the recent price of $10.22 per unit, that would produce a 7% annual cash yield. Since the current yield of the trusts in the portfolio is slight over 8%, that does not seem out of line. Yes, you can get higher yields from selected individual trusts. But this portfolio should provide a reasonable return and offers a lower risk level that I think is appropriate right now."

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