Even though they don't know what the federal government will do to the Canadian income trust sector next year, analysts at Canaccord Capital Corp. have developed a defensive strategy for investors in case the tax regime turns sour on the popular investment vehicle.
In a 100-page report released yesterday, the Canaccord income trust team highlighted a disconnect between the performance of trusts and stocks since September as proof that uncertainty over Ottawa's next move is negatively affecting income trusts. During that period, for example, utility trusts underperformed utility stocks by about 15 per cent, according to Canaccord research.
The same is true when comparing business trusts with stocks listed in the consumer staples and industrial indexes on the Toronto Stock Exchange.
"It is quite clear that uncertainty over potential government changes has negatively impacted income trusts," Canaccord analysts said in the report. "The constructive questions at this point may not be 'what will the government do?' or 'when will it do it?' The truth is -- we don't have a clue."
The most immediate defensive strategy for investors may be to simply sell their trust units. However some analysts have predicted the government will not make drastic changes come January, which would leave investors that sold early out in the cold.
"[If] the government makes little or no changes after completing their review and trust units rebound, investors would have effectively captured the recent lows in the group and missed out on the rebound," Canaccord analysts said. "The term 'whipsawed' springs to mind."
Canaccord's strategy focuses on the types of trusts that may avoid negative tax implications. The research team recommends trusts that could avoid or defer a new tax by possibly utilizing previous tax losses or tax pools (such as royalty trusts), or having foreign income that attracts little or no Canadian tax.
The team also recommends trusts that are able to revise capital structures to include more debt and interest deductibility, and trusts trading at a meaningful discount to net asset value, where assets could be sold to surface this underlying value, such as pension funds buying real estate.
Canaccord also recommends trusts previously suggested by the government to be spared, such as real estate investment trusts, royalty trusts and even infrastructure trusts, as well as trusts with low payout ratios, limiting distribution cuts even with a new tax.
Given the sector's decline over the past few months, Canaccord also suggests looking at trusts that have already fallen so far that a tax change may not affect their value.
"Trusts could still go up or down, depending on the government's actions, but after seeing around a 15-per-cent reduction in unit prices related to this issue already, the downside is less than it was," Canaccord analysts said. "So investors willing to invest in the area should realign their portfolios to limit their downside risk but still be able to participate in a possible rebound in the sector."
Trustworthy
Canaccord's recommended trust portfolio:
Royalty trusts
z Baytex Energy Trust
z Canadian Oil Sands Trust
z Sequoia Oil & Gas Trust
z Power and pipeline trusts
z Calpine Power Income Fund
z Great Lakes Hydro Income Fund
z Diversified business trusts z A&W Royalties Income Fund
Energy service trusts
z Badger Income Fund
z Builders Energy Services Trust z High Arctic Energy Services Trust
z Peak Energy Services Trust
REITs
z Primaris REIT
z CHIP REIT
z CAP REIT
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