Understanding income trusts
By Jim Middlemiss • Bankrate.com

Investors disappointed with the measly interest rates paid by bonds these days might want to look at income trusts for a better return.

Most income trusts pay yields in the high single and even double-digit figures, a far cry from the lowly two to three percent that Canada Savings Bonds pay.

But be forewarned: income trusts, also known as royalty trusts, are not for the faint of heart. They are equity investments, not fixed-income investments, and what investors gain in yield, they sacrifice in safety.

"We view them as aggressive and volatile investments, and for the most part that doesn't suit our clients," says Greg Phillips, a Calgary investment representative at Edward Jones.

"Trusts can have a place in a portfolio, but it's wise to understand all the risks being undertaken," says Adrian Mastracci, a fee-only financial adviser at KCM Wealth Management Inc. in Vancouver. "Investors forget that trusts behave like equities, as opposed to fixed income. There's little fixed about them."

Income distribution is not guaranteed
Income trusts have been around since the 1980s. But it's only in the past few years that they've hit their prime and been one of the best performing asset classes, as investors sought income protection from the vagaries of the dot-com stock market bubble.

According to the Investor Education Fund, a nonprofit educational Web site established by the Ontario Securities Commission, an income trust as "an entity that holds underlying assets or groups of assets." Investors buy units in the trust and most of the income those assets generate is distributed to the unit holders in regular payments.

Income trusts trade on a stock exchange, such as the TSX, and are identified as a trust through the use of the initials ".UN" at the end of the ticker symbol, such as FDG.UN.

The trust structure is attractive because it allows income to flow to unit holders without being taxed at the corporate level. Rather, it's taxed in the hands of the unit holder, but at a more favourable level than as income or dividends. Part of the proceeds is considered return of capital, and the tax is deferred on that portion until you sell the investment.

It's this tax attraction that has seen many companies convert their businesses into income trusts recently. A corporation usually retains its earnings and reinvests them into the company, while possibly paying a small dividend to shareholders. There is a greater chance of growth as the company expands thanks to the reinvestment.

But as an income trust, the business pays its earnings to investors. But that payment is not guaranteed. If the trust encounters a hiccup in its business plan, it may interrupt the distribution of its earnings, which means its share price would plummet and investors would be left with no cash flow.

Phillips adds that because trusts pay out most of their earnings, the only way they can grow is to take on more debt or cut distributions, both of which may have a negative impact on investors.

Don't expect to continue seeing 15 percent returns
Investors can buy income trusts individually or through mutual funds, which can invest in a range of trusts. The other alternative is investing in trusts through one of the growing number of exchange-traded funds, such as the iREIT from Barclays Global Investors, which trades under the ticker symbol XRE.

According to Gavin Graham, director of investments at the Guardian Group of Funds, which manages the successful GGOF Monthly High Income Fund, investors shouldn't expect to double or triple their money by investing in a trust. "That only happens on a rare occasion," he says.

"Most people look at these things as a replacement for GIC income," but that's a mistake, says Mastracci. Investors simply look at the attractive yields from the past couple of years and jump on them.

But trusts can turn sour -- for example, some have cut their distributions, which has had a negative impact on their trading price and left investors reeling.

Phillips predicts that rising interest rates will siphon investors away from income trusts and drive down unit prices as investors look to lock in capital gains and reduce their risk by moving to the safer confines of bonds.

How to recognize a good trust
There are now about 150 income trusts in Canada, which can be broken into four categories: real estate, oil and gas, business and power and pipelines.

Leslie Lundquist, lead portfolio manager with the Bissett Income Fund, says it's important to research trusts before buying them because the distributions are not guaranteed in size or frequency. "You need to get down to looking at the financial statement and reading the annual report and quarterly reports," she says.

Below are her guidelines for how to pick a good trust in each category:

Real estate investment trusts (REITs). These invest in various types of properties, including residential, industrial, commercial, retail and lodging. With REITs, Lundquist suggests examining the net asset value of the trust and how much you'll actually pay for it. "If it's substantially more, look around for something different," she says.

You should also look for information about leases. When are they due? What is the occupancy rate? What type of properties does the REIT invest in? Hotels are the most volatile product, whereas residential units are more stable. You should also keep an eye on debt levels and when mortgages must be renewed. Because interest rates are rising, REITs could face higher mortgage costs in the future.

Oil and gas trusts. These invest in oil- and gas-producing properties. For this category of trust, Lundquist says it's important to look at a trust's reserves and its ability to acquire new production. She says reserves of less than eight years should be cause for concern. As well, oil and gas trusts must continuously replenish their inventory, so the ability of a trust to acquire productive assets or drill its own wells is important to continuing the distributions.

Business trusts. This is the largest category and features a broad range of businesses, everything from sardine canning to Yellow Pages advertising. For business trusts, Lundquist says investors should look for a mature company that dominates a stable industry. It should have a minimum of a two- to five-year track record of producing consistent financial statements. The company must also be able to generate cash flow and require minimal reinvestment in the business.

Power and pipelines. These are energy trusts that involve hydro and pipeline companies. For this category, Lundquist says you should closely examine leverage and debt levels.

Investors can check the stability ratings of certain trusts at the Web site of credit rating firm Standard & Poor's.

Like any investment, diversification is the key and investors should not focus their attention solely on one type of income trust. A fund that invests in a range of income trust products can help reduce risk.

Jim Middlemiss is a freelance writer and lawyer based in Toronto. He's a frequent contributor to National Post, Investment Executive and Wall Street & Technology.