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Forget bubble talk about income trusts

These vehicles have blossomed to the point that the market may have topped out but they're still attractive if you're looking for income, ROB CARRICK writes

All the talk about the income trust sector being a bubble is just so much hot air.

Yes, one of the hottest stock market niches of the past 2½ years still has legs. As long as you buy income trusts for the right reasons, you should find them to be a rewarding long-term investment.

Income trust is a general term for an enterprise that pays its profits to unitholders in monthly or quarterly cash distributions.

There are oil and gas royalty trusts, real estate investment trusts (REITs), pipeline trusts, power-generation trusts and business trusts, examples of which involve fast-food burgers, cheque printing and sardine canning.

The common thread is the potential to deliver capital gains, like a stock, while also paying substantial income, like a bond. Yields can range from 8 to 12 per cent.

Maybe you've heard some alarming things about trusts recently. Sizing up their excellent performance over the past three years, some market watchers see an overheated market primed for a knockdown.

In fact, trusts did go through a fairly significant sector-wide pullback in November. This represented a buying opportunity for some of the quality trusts that were affected, but let's leave that issue aside for a moment and look at where trusts are now and where they're likely to go next year.

First, the "bubble" issue needs to be addressed.

In a recent issue of Gordon Pape's Internet Wealth Builder newsletter, independent analyst Tom Slee took a swipe at the use of this term, while commenting on news that trusts will continue to be excluded from the S&P/TSX composite index. Including trusts would have silenced some of the talk about trusts being a bubble set to burst, Mr. Slee wrote.

"That is not going to happen, even if some smaller, weaker trusts may run into trouble. Trusts are here to stay. They just need some more respect and acceptance."

The manager of one of the largest income trust mutual funds in the country sees both good and bad aspects to the use of the B-word to describe trusts.

"Half of me thinks it's idiotic," said Leslie Lundquist, who oversees the $432-million Bissett Income Fund. "You think, why do they keep using that stupid word, can't we get a bit of balance here?"

But Ms. Lundquist also said the bubble talk serves a purpose in helping to quell investor expectations for the trust sector.

There's good reason for expectations to run high. The Scotia Capital Income Trust Index, a benchmark for trusts listed on the Toronto Stock Exchange, is up about 9.3 per cent so far this year, after gains of 23.5 per cent in 2001 and 28.4 per cent in 2000.

One of the major reasons why trusts blossomed is the awful performance of the stock market over the past few years. Even on a straight yield basis -- never mind the capital gains -- trusts look wonderful by comparison.

Unfortunately, a sustained stock market rally can be expected to have just the opposite effect on trusts.

"If we see a really strong stock market, you have to expect that we're going to lose some investors who are in the trust market," Ms. Lundquist said.

Low interest rates have been a big support for trusts as well. Trust yields are tantalizing at a time when a 5-per-cent return on a government bond is impossible to find unless you're willing to lock your money up for longer than five years.

Few people expect interest rates to surge in the year ahead, but there's little doubt that the trend for rates is an upward one. Now, how happy are you going to be getting an 8-per-cent yield from a trust, when it could soon be possible to get something similar from a less risky bond?

A complication here is that if you hold trusts outside of a registered retirement account, they have a decisive edge over bonds in that their distributions are taxed less heavily than interest income.

Trusts have enjoyed a long honeymoon with investors, in more ways than just great returns.

About 75 trusts and closed-end investment funds holding trusts have come to market in the past two years, some of them based on businesses that don't inspire a lot of confidence in their ability to make cash distributions through thick and thin. And yet there hasn't been a single high-profile case of a trust drastically slashing its cash payout during that time. For that, you have to go back to 1999 when Luscar Coal cut its distribution.

Sooner or later, another cut will happen. And when it does the entire trust sector will suffer.

"There are going to be some negative surprises," says Bruce Campbell, an investment counsellor in Oakville, Ont., who has written on the subject of trusts and also buys them for his clients.

"There are something like 150 trusts out there and not all of them are going to have their business plans work out."

How big a hit can a trust take? When the trust market stumbled in 1998, a well-regarded REIT called RioCan Real Estate Investment Trust (REI.UN-TSX) went to below $8 for a short period from $11 (it is now trading around $12.50).

Even worse is in store if you own a trust that slashes its distribution. First, the yield you receive on your trust units will fall. Second, the unit price of the trust will likely decline as well.

The November setback for trusts can be blamed partly on the strong performance of the stock markets, and partly on the fact that the trust market got to a point where it was getting oversaturated by the introduction of something like 40 new trusts this year.

In fact, several initial public offerings of trusts were either pulled or postponed last month in response to a lack of interest from big buyers such as trust-holding investment funds. In this glutted market, trust prices naturally weakened.

Ms. Lundquist said the problem here isn't that demand for trusts has dropped off a cliff, or that the market has topped out. Rather, it's that too many new trusts came to market in too big a cluster.

One of the interesting things about the trust boom is that it has been driven almost entirely by demand from retail investors. Pension funds have avoided trusts because of a concern that trust unitholders could be held liable in a situation where the trust goes bankrupt or is involved in a major lawsuit.

Some experts say this liability risk is only theoretical and would not stand up in court. Still, there's sufficient concern to keep institutional investors away.

Trusts have a bright future, but let's be clear: the boom years are over for now.

Last spring, Mr. Campbell, the investment counsellor, wrote an article for Canadian MoneySaver magazine saying that income trusts were a "good short-term area to have some exposure in the current volatile markets."

Now, he says, "I'm a lot less positive."

What he means is that it's unlikely you'll be able to buy some trusts, or a trust mutual fund, and receive double-digit total returns.

In fact, many trust experts see a year ahead in which these securities will deliver their cash distributions to unitholders, but not much in the way of capital gains.

At the GGOF Monthly High Income Mutual Fund, the country's largest income trust fund, they say investors can expect to collect the yield on their trust distributions in 2003, plus or minus one to two percentage points.

If you want income, then, consider trusts. Specifically, look for trusts that have the most stable businesses and the best records for uninterrupted payment of distributions. If you use this approach, you'd probably stay away from trusts in cyclical, trendy or highly competitive businesses.

Once you've picked a diversified group of trusts, let 'em ride. The price may go up or down somewhat, but the flow of income will continue unabated if you've picked well.

If you don't feel confident picking your own trusts, buy an income trust mutual fund or a closed-end fund that focuses on this sector. Think of a closed-end fund as an exchange-traded mutual fund.

Fresh off their November setback, trusts might appear to be a slowly deflating bubble. Don't buy it. "The trust market has paused," Ms. Lundquist says, "but it's set to do well for investors going forward."


Leslie Lundquist, lead manager for the Bissett Income Fund

Oceanex Income Fund (OAX.UN):

An intermodel transportation company that ships freight to and from Newfoundland.



Pembina Pipeline Income Fund (PIF.UN):

Transports oil and natural gas in Western Canada



Connors Bros. Income Fund (CBF.UN):

One of the world's largest producers of canned sardines.



Bruce Campbell, an investment counsellor in Oakville, Ontario

RioCan Real Estate Investment Trust (REI.UN):

Canada's largest REIT by market capitalization has retail holdings across the country.



Davis and Henderson Income Fund (DHF.UN):

Supplies cheques to Canadian financial institutions.



Atlas Cold Storage Income Trust (FZR.UN):

Operates distribution centres for frozen-and chilled-food processors and retailers.



Note: All returns are one-year return on unit price except for Davis and Henderson Income Fund which is year-to-date.

© The Globe and Mail

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