A new investment beast: the high-yield corporation

Income trusts, the sequel. Watch for it soon in an investment portfolio near you.

Income trusts as we know them will largely be gone by the time a new trust tax kicks in next year. In their place will be a new category of stock that in some cases will be more attractive to some investors than trusts were.

"I'm calling it the high-yielding corporation," said Harry Levant, the independent analyst behind the IncomeResearch.ca website. "It's a new beast that has come out of the income trust process and demand for income."

As an income trust, a business can distribute its earnings to shareholders and thereby pay no tax. Concerned by what it described as tax leakage, the federal government announced that trusts would have to start paying taxes in 2011 (real estate investment trusts meeting certain conditions were excluded).

Some trusts have already converted into dividend-paying corporations, and most others will follow in the next six months. What will end up distinguishing these trusts is the amount they pay out in dividends.

In the case of a select few financially strong trusts, the amount paid in dividends will be the same as was paid previously in distributions. In non-registered accounts, this is a significant improvement for investors.

Income trust distributions can in part be made up of dividends and a return of capital, but often they're straight income that gets no special tax treatment. Dividends, on the other hand, benefit from the dividend tax credit when held outside registered accounts.

Someone making $60,000 a year would pay a marginal tax rate on straight income of between 29 and almost 39 per cent, depending on the province or territory. On eligible dividends - that's what almost all publicly traded companies pay - the marginal rate would be 4.4 to almost 16 per cent.

"If a trust continues to pay out the same amount in dividends as they were paying in distributions, it's actually an increase," Mr. Levant said.

The difference in taxation on dividends and straight income is so pronounced that investors in non-registered accounts may end up with the same amount of after-tax cash even if a trust reduces its payout in converting to a corporation. In rough terms, $1 in dividends is equivalent after taxes to income trust distributions of anywhere from $1.20 to $1.40 or so.

Trusts converting to corporations are taking a variety of approaches to their dividend. IESI-BFC Ltd., previously known as BFI Canada Income Fund, cut its payout to 50 cents a share from $1.82 on conversion to a corporation, while Yellow Pages Income Fund has said it will maintain its 80-cent annualized distribution through 2010, then start paying dividends at an annualized rate of 65 cents next year.

And then there are trusts that have either converted into corporations and maintained their payout, or indicated they will do this once they make the conversion. According to Mr. Levant, this group includes Canadian Helicopters, Brookfield Renewable Power Income Fund, Colabor Group, Cineplex Galaxy Income Fund and Keyera Facilities.

Mr. Levant said he expects there to be at least three trusts left in 2011 - A&W Revenue Royalties Income Fund, Inter Pipeline Fund and Firm Capital Mortgage Investment Trust. Each has specific reasons why they're not immediately going corporate; Mr. Levant expects the net effect to be a no-change policy toward the distribution heading forward.

At their peak, there were about 265 income trusts listed on the Toronto Stock Exchange. Takeovers and privatizations will reduce the total number of high-yield corporations to around 90, in Mr. Levant's estimation.

High-yield corporations will occupy much the same niche in the investing universe as trusts do now. Yields will be well above what the typical blue-chip corporation pays, but with a higher level of risk of dividend cuts. Colabor Group and Premium Brands, a pair of former trusts that kept their payout intact when they converted to corporations, both have yields in the 9-per-cent range.

The concept of the high-yield corporation is one that has already caught the eye of the indexing people at Standard & Poor's. They're currently deciding what to do with the S&P/TSX income trust index and one option is to convert it into a benchmark for former trusts with high dividend yields.

"We're going to go away and do some research on that," said Tony North, S&P's director of index operations in Canada. "We already have the dividend aristocrats index, but we may create something other than that."

The S&P/TSX Canadian Dividend Aristocrats Index is a mix of common stocks and income trusts that meet various criteria, including a history of raising their dividends or distributions for five successive years. The yield for the aristocrats index was 5.2 per cent late this week, compared with 8 per cent for the income trust index.

Another sign that high-yield corporations are for real can be seen in what executives at the 50 biggest income trusts have been doing with their shares for the 12 months to May 31. An analysis for this column by INK Research, a Vancouver company that tracks insider buying and selling, shows that insider holdings declined only marginally during a period when they could easily have fallen sharply.

For one thing, the average one-year price gain in the group was 40.3 per cent. "In a strong market upswing, I would have expected to see more profit-taking," said INK chief executive officer Ted Dixon.

Uncertainty about the new trust tax in 2011 and conversions into a corporate structure might also have prompted insider selling, Mr. Dixon said. And yet, the average insider holding in the top 50 trusts was just down just 0.3 per cent when adjustments are made to reflect unique circumstances at two particular trusts.

A question that income-seeking investors will no doubt have about high-yield corporations is whether they will pay their dividends quarterly, as is the custom with corporations, or monthly, as most trusts did. Monthly is obviously preferable from the point of view of someone who wants consistent income.

Mr. Levant said the trusts he expects to pay monthly include Canadian Helicopters, A&W, Brookfield, Chemtrade, Firm Capital and IPL. This column will try to present a master list of monthly payers once more trusts announce their conversion plans.

Traditionally, a dividend yield of much more than 5 to 6 per cent on a stock was considered a sign of investor concern (remember, yields rise when share prices fall). But Mr. Levant's view is that an aging population of people who need investment income may embrace high-yield corporations that were once trusts.

Once investors live with these companies for a while, they may bid up the price of the best of them and thereby squeeze their yields lower. It's possible that some of tomorrow's top dividend stocks are in this group.

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