Income trusts with a future

Income trusts as we know them have 14 months to live. Care to buy some?

Once the most talked about kind of investment in the country, income trusts shrink in influence day by day as we head toward the introduction of a new federal tax on trusts in 2011. The recession hasn't helped. Virtually all businesses are struggling, but trusts as a group have exhibited a notable degree of flimsiness.

Ignoring them seems prudent then. But what if there were some trusts that offered good potential? Wouldn't you want to know about them at a time when interest rates are low enough that the big banks are posting a rate of 0.4 per cent on one-year guaranteed investment certificates?

Presenting a list of income trusts with a future as chosen by a veteran independent analyst, Harry Levant of IncomeTrustResearch.com. Mr. Levant has analyzed close to 200 trusts and what he calls high-yield corporations (trusts that have remade themselves as corporations in preparation for 2011). The best of the bunch have been posted to his website and, he has allowed us to reproduce the trusts on the list here.

You'll find all trust types represented on the list, including pipelines, electrical power generators, oil and gas royalty trusts, business trusts and real estate investment trusts, the one trust category where there will be some exemptions from the 2011 tax.

The names on the list made it the old-fashioned way. They earned it by being strong, steady businesses that generate lots of cash.

Surprised? The standard criticism of the trust sector is that it's a dumping ground for second-rate businesses. Got a division in your corporation that you don't know what to do with? In the early part of this decade, the easy answer was to spin it off as an income trust.

"There's a view that some trusts weren't strong enough businesses to exist in some other forms, that they were bad quality assets," Mr. Levant said. "But a lot of them don't fit that bill. They're very strong business with strong brand names and strong business positions."

Before we look at examples, some context is needed. Many trusts have already converted themselves into corporations as 2011 approaches and it's expected that virtually all the rest will either do likewise or be acquired. Unfortunately, it's pretty much standard procedure for a trust becoming a corporation to lower the amount of cash distributed to shareholders each month or quarter.

For his list, Mr. Levant has chosen trusts with the financial strength to theoretically keep on paying their distributions even after the new trust tax kicks in. But in converting to a corporate structure, these businesses may well choose to set dividends at a lower level. So beware. Even strong trusts may end up paying less cash in 2011.

What makes a strong trust? For Mr. Levant, it comes down to the ability to generate enough cash to pay shareholders, cover debt and retain something for reinvestment. He looks closely at payout ratios, which measure the percentage of earnings paid out as distributions.

Some trusts on the list - notably those in the pipeline and electrical generating businesses - benefit from having a stream of revenue that is locked in by contract. Inter Pipeline Fund and Pembina Pipeline Income Fund are examples, as is Brookfield Renewable Power Income Fund .

Other trusts on the list benefit from their strong business models. Mr. Levant cited CML Healthcare Income Trust , which is the country's largest provider of medical imaging (X-rays, MRIs, etc.) and is also big in medical diagnostics like blood testing. Other strong businesses include A&W Revenue Royalties Income Fund , which is based on sales generated by the popular A&W burger chain, and Cineplex Galaxy Income Fund , which operates a chain of movie theatres.

The primary reason to own trusts is to benefit from yields that are higher than bonds, GICs, dividend-paying common shares and preferred shares. The S&P/TSX income trust index had a yield of 7.7 per cent late this week, which compares to 2.7 per cent for the S&P/TSX composite index and about 2.5 per cent for a five-year Government of Canada bond.

Remember, there can be too much of a good thing with trust yields. Mr. Levant said that anything over 15 per cent raises the question of whether a trust is experiencing problems and might have to cut its distribution.

He believes that between 10 and 14 per cent, it's possible to find some good values. Yields in this range may reflect an overly large discount due to general market fears and uncertainty about what's ahead in 2011. "If I had a favourite approach, it would be to find something that's nice and solid in the 10- to 12-per-cent range. That essentially says the trust tax is factored in [to the price]"

Among the trusts in this category are Pembina, Parkland Income Fund , AltaGas Income Trust and, until a recent run-up, A&W.

Almost all the trusts on Mr. Levant's list have moved up nicely this year, but the three-year view looks pretty bad for many. Skepticism reigns in this sector, even if it still has its stars.

Top trusts

*Cumulative return

**Based on consensus ratings on Globeinvestor.com reflecting the opinions of as few as one analyst