Income Trusts 101

02/25/2005 12:00 am EST


Roger Conrad

Chief Analyst/Managing Partner, Capitalist Times

Roger Conrad, a leading expert in the utilities sector, has expanded his research coverage to the world of Canadian income trusts. In Orlando, he hosted a Q&A session for subscribers to his new Canadian Edge newsletter to explain the basics of income trusts.

What are Canadian royalty trusts?

"Canadian trusts are basically a form of business organization made possible under Canadian tax law. Like corporations, trusts operate businesses. But they're granted special tax status, which allows them to pay dividends from pre-tax cash flows, rather than post-tax earnings as is the case with ordinary common stocks. Since pre-tax cash flow is always far higher than post-tax earnings, trusts can pay out much larger dividends than ordinary common stocks, even after taking out a certain amount to reinvest in the business.

"The typical Canadian oil and gas royalty trust currently yields anywhere from 9% to 15%. Canadian electric power trusts yield 7% to 10%, versus 4% to 5% for the average US utility. Canadian REITS yields are more than twice those of comparable US REITs. Note that most trusts also pay dividends monthly, rather than quarterly like most US corporations.

How do I buy these trusts?

"You buy and sell trusts on stock exchanges, just like common stocks. A number are actually traded on major US exchanges, or over-the-counter on the pink sheets in the US. The home market for these trusts is the Toronto Stock Exchange, Canada's most important place to trade stocks and a venue that's available to most US brokerages. I generally prefer to buy trusts that don't trade on US exchanges, as they're not as heavily purchased by US investors and are often cheaper.

"Whether you choose to buy over-the-counter, on a US exchange, or on the Toronto market itself, your broker should be able to make the trade for you without imposing additional fees and spreads. Unfortunately, reality is often quite different. Many US brokers refuse to buy trusts for their clients on the false basis that they're too 'risky.' Others impose hefty fees on the basis that you're dealing in a foreign market. And still others can't even get dividend payments right. Because of these pitfalls, executing your trades correctly is almost as important as picking the right trusts. That means either educating your broker if he or she is errant, or else finding another one with the skills and motivation to get the job done.

How are these trusts taxed?

"The Canadian government assesses a flat 15% tax on trust distributions to US investors who hold trusts outside of IRAs. The tax is withheld at the clearing corporation level, not at the brokerage or the trust. This payment can be recovered when you file your US taxes with Form 1116 of your 1040, essentially filing a foreign tax credit. Uncle Sam taxes trust dividends as a qualified corporation at a maximum rate of 15%. The only exceptions are the tiny handful of trusts that are passive entities, i.e. don't actually operate businesses.

"Trusts held inside an IRA are in a slightly more complicated situation. Under the reciprocity agreement, the IRS and its Canadian counterpart, Revenue Canada, do not tax retirement accounts of each other's citizens. However, unless a trust is considered 'DTC eligible' or is cleared at the Deposit Trust Corp., the odds are it will be withheld anyway. American investors can still reclaim this money by filing Form NR7-R, a complicated process that could be well worth the effort if you own significant shares. In any case, trust dividends are still very attractive, far above equivalent investments in the US, even if no attempt is made to recover the tax from the Canadians.

How are trusts different from US limited partnerships?

"Basically, the structure is very similar as both pay dividends from pre-tax cash flows. The main difference for US investors is the tax status of US LPs, which require the filing of a K-1 and sometimes generate what's called  unrelated business taxable income. US LPs also break down their dividends into tax-deferred return of capital and ordinary income, which is taxable at the unitholder's regular rate. In contrast, virtually all trusts' dividends are considered qualified from the IRS' point of view, and are taxable at a maximum rate of 15%.

What kind of businesses do trusts operate and what are their risk and potential rewards?

"The single largest portion of the trust industry is involved in the exploration and production of oil and natural gas. Trust structure is ideal for this business, as it permits capital to be raised for developing 'second tier' reserves, which have already been developed but still have additional life. Oil and gas trust prices largely determine how much in dividends a trust can pay. Consequently, oil and gas trusts tend to be fairly volatile over time and represent the riskiest segment of the trust sector.

"The tradeoff is that the sector also boasts the highest yields in the trust universe. Some have doubled and tripled in the past couple of years. But investors should be prepared to take a hard hit if energy prices should back off. The damage could be magnified by the fact that many trusts have been forced to buy new reserves at high prices in order to replace production, pushing up their cost structures.

"Oil and gas, however, are only one small part of the total trust universe, which now encompasses virtually everything from the telephone directory business to hydroelectric power production and pipelines. Generally speaking, power and pipeline trusts have the least operating risk to their dividends. Canadian REITs are next, followed by business trusts and natural resources. Note that safer trusts could prove to be more at risk to rising interest rates than riskier ones. Power trusts, REITs, and other trusts have also had a strong move in the past year.

What criteria do you use to pick trusts?

"I start with the basic business, with an eye toward minimizing risk. Even the safest trusts' dividends are far above their US counterparts. I optimally want the bulk of my trust holdings to be in a diversified basket of the best trusts in each sector, but the focus should be on the more stable fare. I then look to see how long a trust has been around. Less than a year of life is generally unacceptable, as there's not enough of a track record to assess dividend safety.

"The payout ratio is another important figure, though my calculation is based on 'cash available for distribution' which takes into account trusts' tax advantages, rather than post-tax earnings, which are essentially meaningless when it comes to looking at trusts. A strong rating for dividend stability is another plus, indicating both financial strength and transparency. After I've gotten a handle on the fundamentals, I look at valuation, chiefly whether or not dividend growth has kept up with the share price. Trusts' unit prices always match their distributions in the long haul. I set very disciplined buy targets in order to avoid overpaying.

How does the Canadian dollar vs. US dollar exchange rate affect trusts?

"When the Canadian dollar rises, the US dollar prices of trusts rise. So do the value of dividends. When the US dollar rises, trusts' US dollar prices fall, as do the values of dividends. However, the roles can be reversed when it comes to the impact on trusts' businesses. Those that do business south of the border, for example, will take a cash flow hit if the dollar declines. So will cash flows of oil and gas producers who don't hedge their currency exposure, since oil and gas are priced in US dollars. Conversely, a rising US dollar will help oil and gas trusts' profits. Overall, though, a rising Canadian dollar is good for trusts and trust investors.

What’s a good target percentage for trusts in my portfolio?

"Canadian income investors can devise a portfolio of 100% royalty and income trusts, provided they choose well and diversify. On the other hand, if you're paying your bills in US dollars, having a 100% trust portfolio leaves you vulnerable to currency swings. Consequently, trusts should be considered just another part of a diversified income portfolio, with a target percentage of 20% or so.

What are you predictions for oil prices and the exchange rate?

"I'm no fan of the record and rising US trade and federal budget deficits. Unless these are reversed, the US dollar is going to decline against the currencies of its trading partners like Canada. Canada is also advantaged in that it's a resource economy and high commodity prices boost demand for its currency. I think it's entirely possible we'll see parity between the two currencies, a feat last achieved back during the 1970s. But the road there is going to be rocky and uneven, as the US dollar's rally in the past couple of months shows.

"As for oil, the last bull market ended only with a global recession, the adoption of alternatives such as natural gas in power generation, conservation with the switch to smaller cars and a massive discovery and production increase for oil in the North Sea. None of those things have happened yet, leading me to believe that oil can go a lot higher. I t won't be a straight line and there's still the chance rising inventories this spring could bring oil back down through support at $40 per barrel, and possibly sink it into the $30 range. It would be unlikely to stay there for long, given soaring demand for the fuel worldwide. But it could do some damage in the near term to oil and gas trusts, another reason for not overpaying for trust shares now.

How would trusts fare if the S&P were to fall 30%-40% in a short time?

"The answer really depends on why the index fell. If it were to do with rising interest rates and inflation, some of the trustsparticularly those with the most stable businesses could get clipped. Oil and gas and other energy trusts, however, could do extremely well, as energy prices would likely follow inflation. If the market fell because the economy fell apart, we could expect the opposite to happen, i.e. falling energy demand levels oil and gas trust prices, but lower interest rates spur the safest trusts. That's one reason I advocate holding a diversified portfolio that spans several sectors.

What about the inclusions of trusts on the S&P Toronto Stock Exchange composite?

"The effective end of the unlimited liability of unitholders in the event of trust bankruptcyafter the passage of legislation in Ontario last month has brought trusts from the fringes of investing into the realm of respectability. As a result, institutions on both sides of the border will be buying the biggest, most liquid trusts. That should lift prices all around. Being included in the S&P index should earn an additional premium for the biggest trusts, as anyone attempting to mirror the index will have to buy them. The downside is that yields won't be as high for new buyers. But we will also see greater transparency and liquidity for trusts, which may offset this cost even for individual investors.

Can you name some trusts you’d recommend for purchase?

"Yield chasing, the excitement over the arrival of institutions to the trusts market and low interest rates have pushed up prices of trusts in recent months to all-time highs. The challenge faced by investors now is now to overpay for good stocks, and many great ones are now at too high a level to be bargains. That said, there are still a few I like at these levels.

"One of these is Pembina Pipeline Income Fund (CA:PIF.UN  Toronto). Pembina is a low risk way to play the potentially astronomical growth of the Canadian oil sands, which the energy department of Alberta estimates have as much extractable oil as the whole of Saudi Arabia. The leading player is the Syncrude venture—a partnership among several major oil and gas companies—which already produces 13% of the country's oil and expects to ratchet that up to 20% in the next ten years.

"The chief problem of the oil sands is that it's far more expensive to get it out of the ground than conventional oil, so it's economic only at very high oil prices ($35 or higher). That makes stocks of oil sands producers very volatile. As Syncrude's pipeline trust, Pembina is growing rapidly by building and operating infrastructure to handle its rising output. And with most of its business tied to fees, its cash flows could still rise even if oil backs off. It pays a 7.5% dividend, paid monthly, to boot.

Can you recommend a good mutual fund for income trusts?

"There are several closed-end funds which US investors can buy either OTC market in the US or in Toronto. Closed-end funds trade a fixed number of shares and their prices are usually above (premium) or below (discount) the value of their assets. In general, I'd stick with one that's been around for a while, has a good track record, and sells for a discount to asset value. My favorite is Enervest Diversified Income Fund (CA:EIT.UN  Toronto), which pays a monthly dividend at an annual rate of 10%+."

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