As the population gets older, the demand for income products will continue to grow.
If you think about it, retirees and seniors are in a pretty tough place these days.
On one hand, interest rates remain at low levels and while they are expected to rise, they're not expected to rise that much. On the other hand, the markets haven't rewarded investors for risk premiums over the past five years.
Income trusts and other income-yielding investments have been the only place to fill the void for retirees needing income from their investments. But are income trusts the way to go? Here are some things to consider:
Performance v. stocks
Without question, one of the most important contributors to the euphoria of income trusts is past performance.
The CIBC World Markets income trust composite index, for example, is up 45.7 per cent over the past year, 34.3 per cent compound average return over the past two years and 30.2 per cent over the past three years. For longer-term numbers, the Morningstar Canadian income trust index is up 19.3 per cent compound average annual return over the past five years and has a 10-year compound return of 13.1 per cent.
In fact, since the technology bust that began in 2000, the income trust sector has been one of the top performing asset classes.
For the past five years, if you held an income trust in your portfolio, it was probably one of your best investments.
The problem is this: That was the past five years and, based on the fact that everything goes in cycles, the next five years is likely to be very different.
Income v. capital gains
In a world of continued uncertainty, investors are finding some comfort in the fact that some investments, like income trusts, provide a regular steady flow of income. Income trusts are designed to pay this stream of income. Investors today, particularly retirees, like the notion of getting something back from their investment, unlike stocks where returns are purely predicated on movements of price.
Perception of risk
Income trusts are relatively new vocabulary for most of us. They're an asset class that most investors have only experienced in the past few years.
Because of this time horizon, most investors of income trusts have not faced sever downturns or risks with those holdings. Most investors, in comparing their income trust experience with the stock market, view income trusts as much more conservative.
I have heard many investors go so far as to say they have little to no risk. While this perception of risk is not true, the general public does feel that the income trust is a much safer asset than holding stocks.
But trusts went through corrections in 1990, 1994 and 1998. In fact, the correction in 1998 saw income trusts drop almost 20 per cent in one month. Income trusts have more risk than investors think. What has been proven is that adding income trusts as an asset class does reduce overall portfolio risk.
Taxation
Not only do income trusts provide a regular stream of income but they do so in a very tax efficient manner. When you compare their tax efficiency to other assets, there is definitely a competitive edge to the income trusts. This is an issue that is being looked at very seriously by the government.
Some experts argue that the government is losing millions of dollars in corporate taxes. Although we know changes are coming -- Ottawa is reviewing trusts' status -- we wait to see how they will impact retirees and their quest for a happy retirement.
A bubble brewing?
While there are very compelling reasons why investors have flocked to income trusts, there are also reasons for them to proceed with some caution.
A risk of a correction is greater now than any time over the past five years. Income trusts have become an asset class on their own. Their primary objective is to provide a regular stream of tax-efficient income.
Most trusts generate cash by producing a product or service, selling it and using the proceeds to pay for all expenses. What's left after expenses goes to unitholders. The trick to being a trust is that there has to be a lot of cash left over after expenses to generate the distributions. Income trusts are not designed to consistently provide double-digit returns. Investors should prepare themselves for more realistic returns.
In general, an income trust should represent part of the income portion of a portfolio. They are not designed as growth vehicles in spite of some of the more recent returns and should not replace the less-risky bond component of your retirement portfolio.
My 2 cents
My message is simple: Proceed with caution.
With euphoria often comes some level of risk. Investors are enamoured by this asset class and, based on the fundamentals, they should be. However, I can't help but see that too many investors are buying income trusts because of performance alone.
When in doubt, remember some old principles of investing: Diversify your holdings, be informed before you buy and understand the risks of investing.
Jim Yih is an Edmonton-based financial adviser and author of Mutual Fundamentals and Seven Strategies to Guarantee Your Investments.
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