Investors might want to keep some of their royalty trusts even though the federal government will begin taxing them like corporations on Jan. 1, 2011. Indeed, you might even consider making some new investments.
A number of analysts view many of the royalty trusts as takeover candidates. They also see a several of them converting to corporations paying high yields and generating greater rates of growth.
Potential for takeovers Harry Levant, a seasoned income-trust analyst who offers advice at IncomeTrustResearch.com, says "one side effect of the new trust tax is to make royalty trusts buyout targets."
"True, they face a higher tax burden but the news has been discounted," he explains. "Meanwhile, many of them have valuable reserves that make them likely takeover candidates at current, or even higher, prices."
"The year-end financial reports are a crossroads," says Mr. Levant "That's when the trusts report their reserves based on year-end inventory counts. The market will then have up-to-date estimates of reserves and a better idea of the value of the trusts."
Conversions to high-yield corporations Paul Bloom, president of Toronto-based Bloom Investment Counsel, also thinks the uncertainty generated by the tax has resulted in trusts becoming undervalued. The veteran manager of income-trust portfolios has just launched a closed-end fund, Canadian High Income Equity Fund , to take advantage of buying opportunities.
His fund began trading Feb. 18 under the ticker symbol CIQ.UN. A news release explains one reason for creating the fund: "Certain income trusts may outperform in the coming period … as they become takeover targets due to attractive valuations."
Another reason: a number of trusts are expected to outperform after their conversion to corporations. Many of the conversions to date have, in fact, established dividends at levels comparable to trust distributions. As conversions multiply, Mr. Bloom believes a new market for high-income common equities will emerge in 2011 and beyond.
The Case of Crescent Point Energy Mid-cap oil producer Crescent Point Energy Corp. is an example of a royalty trust reborn as a high-yield corporation. When it converted in July, it was able to keep paying the same monthly distribution thanks to its low payout ratio and growth orientation. At current prices, the dividend yields about 7 per cent.
By becoming a corporation, Crescent also enjoys better growth prospects. It is no longer constrained by the government-imposed limitation on trusts' growth. As a result, it enjoys better access to capital markets.
The high-yield corporations emerging from the trust sector are of interest to Bruce Campbell, a portfolio manager at Oakville, Ont.-based Campbell & Lee Investment Management Inc. He prefers plays like Crescent because they have yields comparable to trusts yet the risk of a distribution cut is relatively small compared to existing trusts.
"It's not cheap," admits Mr. Campbell. But he thinks Crescent deserves a premium due to its significant growth prospects: "With acquisitions and interests in the Bakken and other fields, Crescent has 8 to 10 years of drilling prospects. Management may not increase the dividend much but the share price could double in the years ahead," he adds.
Other winners (and losers) Not all royalty trusts will avoid significant cuts to their distributions, warns John Stephenson, a portfolio manager with First Asset Investment Management Inc. Danger signals include: high payout ratios, overleveraged balance sheets, minimal hedging programs and small tax pools. Business models are an important consideration, too.
Three trusts he believes could avoid cuts are: Canadian Oil Sands Trust , which already cut its distribution and is conservatively managed; Arc Energy Trust which has a low payout ratio and is evolving into an oil play; and Vermilion Energy Trust which has a low payout ratio and about two-thirds of its operations are already taxed in other countries.
Three trusts he believes could cut their distributions by a third (or thereabouts) at some point are: Daylight Resources Trust , since its capital expenditure plans plus distribution exceed the cash it generates; Penn West Energy Trust , since it's hard to maintain growth and pay a high yield when a trust gets this big; and Paramount Energy Trust , which is "gassy" and has a short reserve life.
Pat McKeough, editor of The Successful Investor newsletter and founder of www.tsinetwork.ca, likes two trusts in the energy sector. The first is Enerplus Resources Fund and the second is Pengrowth Energy Trust .
Enerplus "pays out only around 55 per cent of its cash flow as distributions, and yields 9.1 per cent. Enerplus has over $2.5-billion in tax losses that it can use to delay its conversion to a dividend-paying corporation until 2013 or later."
Pengrowth's distributions account for "just 40 per cent of its cash flow, so they seem secure. Pengrowth has $3-billion in tax losses that it can use to delay taxation under Ottawa's new trust tax until 2013."
Another consideration is Precision Drilling Trust . The new tax won't affect it because "the trust suspended its monthly distributions in February, 2009 to focus on cutting its debt following its $2-billion purchase of U.S.-based contract driller Grey Wolf Inc.," notes Mr. McKeough.
The trust is now working on paying down its debt. As it becomes more manageable, Precision Drilling could resume its distribution payments, which should have a salutary effect on the unit price.
Hold trusts outside registered accounts Returns will be higher to investors holding trusts outside tax-deferred accounts. That's because they will be eligible to claim the dividend tax credit when the trust converts to a corporation or continues operating as a trust after Jan. 1, 2011.
After-tax returns will actually end up higher for trusts able to maintain their distributions, like Crescent Point. For trusts that reduce payouts by the amount of the tax, the dividend tax credit will keep the after-tax return near, or virtually the same, as the after-tax return previously provided by the trust's distribution.
"Hold income trusts outside of your RRSP," urges Mr. McKeough. "If you … hold income trusts in a registered plan, you will receive a 26.5-per-cent lower distribution, but with no offsetting tax benefits on dividends."
If you already hold trusts in a registered plan, "you should consider swapping them out of your registered plans for cash held in a non-registered investment account," recommends Mr. McKeough.
Risks The ability of royalty trusts to cope with higher taxes is but one of many variables that affect the price of units and size of distributions. A lot depends, in particular, on oil and gas prices. When prices are high, like now, it's easier to continue paying high yields. But if prices tumble, high payouts will be harder to support.
So, although many trusts may be taken over or continue paying high yields, they might be considered only for the aggressive part of income portfolios. Low payout ratios, tax pools, hedging programs and strong balance sheets can hold up yields but they need the co-operation of commodity prices.