Good things with the number three. Rocky 3 gave us the match between Sylvester Stallone and Hulk Hogan. Season 3 of Miami Vice provided our first glimpse of the white Testarossa. And part three of Here a Trust, There a Trust takes a look at some of the issues facing the income trust market. To begin, a number of commentators have expressed concern about possible…

Changes to the tax code
Trusts are able to reduce their corporate taxation by distributing their excess cash flow to unitholders. It has been suggested that CCRA may start sniffing around the sector, looking for their lost tax revenue. Some have gone so far as to warn investors that the trust structure is nothing but a tax loophole, one that will someday be closed. For the life of me, I have never understood this argument. Instead of being taxed in the hands of the trust, the distributions are taxed in the hands of the unitholders. Last time I checked, personal income tax rates were much higher than corporate tax rates. If CCRA closed the loophole, they’d end up with less money. Am I missing something here? Plus, the investing mainstream is beginning to embrace trusts, and a dramatic change to the tax code would incur the wrath of Bay Street and Main Street. I’d hate to be the government official trying to explain such a change to all those cash-hungry, retiring baby boomers (the people who actually vote). The reaction would be similar to the time I mistakenly changed the channel on the Market Gal when she was watching Paradise Hotel. Remember that scene in Return of the Jedi when the evil Emperor, after failing to turn Luke Skywalker over to the dark side, said “Now young Skywalker, you will die!” and then started hitting him with a series of lighting bolts? Let’s just move on to…

Accounting problems
Atlas Cold Storage (FZR.UN) discovered some accounting problems with a number of their previous financial statements. Specifically, the problems had to do with distributable income being artificially inflated when certain expenses were treated as depreciating assets. With a trust, anything that screws around with calculations of distributable income is very serious. However, let’s gain some perspective. This is not necessarily an income trust sector problem. We’ve seen accounting issues and fraudulent activity across just about every sector of the market: energy, tech, mutual funds, hedge funds, etc. There are going to be wrongdoers, especially when financial statements have become so cryptic and art rather than craft. It’s also quite apparent that auditors are able to detect problems with form, but not of substance. While there should be a more standardized approach to dealing with distributable income, the market appears to believe the Atlas problem is company-specific. After the announcement, there was very little collateral damage on the rest of the sector. So far, I’ve been lucky to avoid these problems. However, I have been touched by…

Issues of liquidity
Many of the trusts are small capitalization stocks with relatively few shares in play. This liquidity issue can lead to significant gaps between bid and ask prices. For example, the other day I came across a trust that was bidding $16 but asking $16.75. How am I supposed to make a trade with that kind of spread? Plus, there were only a small number of shares available, so if I swept up all the shares at $16.75, I have no clue at what price more shares are available. $16.80? $17.00? Who knows? And if I’m placing a non-market order, what price do I bid? There’s a good chance my full order won’t be satisfied anyway and then my day is ruined. So I stay away. All this being said, there are many larger cap trusts that are very liquid and avoid these issues altogether. For example, Canadian Oil Sands (COS.UN) has a market cap over $3 billion. One issue that no trust has escaped is that of…

Lawsuits and unlimited liability
It was only a matter of time before we had to talk about lawsuits, or at least the intense fear of lawsuits. Without question, the largest overhang on the sector has been the idea of income trust investors being liable if the trust became the object of a lawsuit. This issue of unlimited liability illustrates yet another difference between most publicly traded companies and trusts. The other day the Market Gal and I were looking for clearance items in the garden section of a department store. The store is owned by a publicly traded company. We were there because I needed a wheelbarrow to help with all the gardening that I never actually do. Unfortunately, all the wheelbarrows were covered in rust because they’d been left outside all summer. A couple even had jagged pieces of rusty metal. Now say I cut myself on the metal, sustain a serious infection, and ultimately end up on that great big trading floor in the sky. Market Gal could sue the company. The example is stretched, so maybe we should go with my being flattened by a rack of low-priced, yet comfortable footwear. If Market Gal sued and won, only the assets of the company could be part of the action because the company is protected under the terms of corporation. In other words, she couldn’t sue the common stockholders because liability cannot extend beyond the company. But say we’re talking about an income trust. Theoretically, she would be allowed to go after not only the company, but the unitholders as well. The mere prospect of unlimited liability has left many investors on the sidelines, including many mutual funds, pension folks, and other institutional investors. Even Standard & Poor’s has refused to allow trusts into their standard equity indices and sub-indices.

However, the past year has seen a significant number of institutions changing tune and participating in the trust market. This is no doubt aided by the dominant legal opinion, that liability risks to investors are extremely low. Just the same, the major players in the trust market have been lobbying hard for provincial governments to use legislation to address the issue of unlimited liability. The Ontario provincial government tabled such legislation earlier this year and it appeared to be sailing along quite nicely. The process came to an abrupt end with the calling of the provincial election. Now the bill will have to be reintroduced. The other province with a substantial number of trust headquarters is Alberta, and it’s hard for me to believe they won’t remedy the situation. To do anything else would be anti-business. Overall, everything I’ve read indicates that trust liability will be removed, but the timetable is unclear.

That being said, let’s place the risk in perspective. Even in the worst-case scenario with a trust being sued and the trial magically transported to Mississippi or California (both known for absolutely ridiculous financial awards), I believe the concerns are overblown. The assets of the trust would be the first to be targeted. Next on the list would be any significant shareholders, such as mutual or pension funds. Only after these sources have been taken out, would Ma and Pa Investor be in the crosshairs. No way am I heaving my Riocan units based on what I believe to be a low risk proposition.

It seems that many institutional players are of similar opinion. Pension operators such as the Ontario Teachers have made substantial investments into Calpine Power (CF.UN), Yellow Pages (YLO.UN) and Fording Coal (FDG.UN). They are not alone. Over the past year there has been an explosion in the number of…

Closed-end mutual funds
By my count, there are currently 87 closed-end mutual funds that focus on income trusts. In fact, 7 new offerings have been announced since mid-July alone. I suspect these new offerings are at least partially responsible for the stellar performance of the sector. There’s a lot of money chasing a few names.

Closed-end mutual funds trade on the stock exchange, so all you need is a brokerage account and you can do business. With a standard mutual fund, you have to wait until after the market close to know the net asset value and the price of your transaction. With a closed-end fund, you know your transaction price when you place the trade. When an investor makes a contribution to a mutual fund, the money is added to the cash position of the fund before being deployed by the manager. Therefore, a popular fund can be in the position of having more cash than it knows what to do with. The larger a fund becomes, the more difficult it can be for the fund to initiate any positions that will add to performance (basically, the fund becomes a victim of its own success). It becomes very difficult to stay fully invested. On the flip side, negative market conditions can lead to a rash of redemptions, forcing the fund to raise cash. This is especially challenging for the smaller funds. Therefore, the investment strategy of the fund can be affected by its open status. By contrast, a closed-end fund has a specific number of units. The amount of cash available is determined by the manager and not by the whims of the investing public.

On the downside, it can be more cumbersome and expensive to make small contributions to or withdrawals from the position. Each time you’ll be hit with the standard trading fee charged by your brokerage. Some closed-end funds have a dividend reinvestment plan, allowing you to use the fund’s distributions to acquire more units at no commission.

I’ve owned Sentry Select Diversified Income Trust (SDT.UN) for a few years. It’s managed by one of the big-wigs in the sector, Sandy McIntyre of Sentry Select Capital. The fund is allocated 25-30% to energy/resource, 25% to REITs, roughly 20% to power and infrastructure, with the remaining in various business trusts. I purchased the fund at a time when I didn’t think I’d be able to keep up with the sector. Well, I underestimated the level of my obsession (occupational hazard of the obsessed, I suppose). I probably don’t need the holding, as I’ve already achieved some diversification by owning a variety of individual trusts. Call it laziness, call it portfolio inertia. The fund has performed just fine, so I let it chug along. Total return for each of the past three years has been 22%, 33%, and 16% respectively. It currently distributes 3.75 cents a month and last year offered a special distribution at the end of the year. Much of the 2002 distributions were treated as capital gains for tax purposes. Another place to research might be the Middlefield Group, which offers a number of closed-end options. Each of their funds has a slightly different asset mix. For example, their Compass Income Fund (CMZ.UN) leans towards the business trusts. Of course there are 85 more closed-end funds we could talk about. Then you’d be feeling as uncomfortable as I did when the Market Gal made me go to a Celine Dion concert.

Beyond the closed-end funds, there are also standard mutual funds with a focus on trusts (I counted 43 when I searched at www.globefund.com). Most of them include the words high income in the title. One choice is the no-load Saxon High Income fund (minimum investment of $5000). It’s been an above average performer in 5 of the last 6 years and comes with an MER of 1.25%. The Bissett Income Fund is another highly-regarded option.

So there is some level of institutional participation in the sector. However, it pales in comparison with what should happen when the trusts receive…

Inclusion in the broader indices
Once the issue of unlimited liability is addressed, expect many of the trusts to be included in the various Canadian S&P indices. This would be accompanied by all those index mutual funds having to come in and pickup the larger names. Some trusts would merit consideration to the S&P 60, while many others would be granted status in the sub-indices. For example, the REITs would come to dominate the S&P real estate index, which currently has only 3 names. This illustrates the point that without trusts, many of these indices do no accomplish what they were created for: to provide an accurate reflection of the Canadian markets. Although this sounds bullish, my enthusiasm is somewhat tempered after I look at…

Current valuations
It used to be that finding value in the trust sector was like finding illegal music on a dorm computer. What could be easier? The party has been going on for a while now and I can’t help but think many of these trusts will be available at cheaper prices. In the current low-interest rate environment, investors are willing to pay a premium for yield. This won’t continue forever. Even though the underlying businesses for many of the trusts will do well with an expanding economy, there is a point at which rates will begin to erode the unit prices. In the meantime, I’m content to maintain a healthy exposure to the various trust sectors (with an underweight in energy, for now). I’m expecting my monthly distributions, but not much by way of capital gains.

Yes, I think trusts are here to stay and there’s going to be a lot of new product being thrown at us. Some will be good, some not so good. The fun part with all the new issues is that trust conversion has been able to breathe life into stodgy businesses, and provide alternatives for both the companies involved and the investing public. However, it’s only a matter of time before trusts will shift from being the hot number to becoming just like any other asset class. In other words, they will be fully entrenched in the investing mainstream. Since this is inevitable, it pays to know more about trusts. I’ve found some very useful information on a variety of…

Income trust websites
Some of the best websites devoted to the sector are offered by the companies themselves. At the very least, each site should offer the latest news releases and quarterly reports, information on the management team, a detailed distribution history (including how the distributions have been treated for tax purposes), and a profile of the companies assets and/or services. Some even have FAQ’s that are quite informative. You can find the addresses by heading to www.globeinvestor.com, entering the ticker symbol, and selecting Company Snapshot. Web contact information is presented near the bottom of the page. The next step would be to consult some of the…

Proprietary research
In terms of the discount brokerages, I’ve found CIBC Investor’s Edge to provide the most thorough research available. This is hardly surprising, as they also happen to be one of the top underwriters in the trust market. In addition to covering a wide assortment of trusts, they produce a weekly sector review called In Yield We Trust. TD Waterhouse and Scotia McLeod Discount provide only a modest amount of coverage. I have no dealings with the other brokerages, so I don’t know how they approach trust research. Overall, there are still a large number of trusts receiving only modest or no analyst coverage at all. As trusts become more and more part of the investing mainstream, this is likely to change.

Trading Note
I recently initiated a position in Superior Plus Income Fund (SPF.UN; currently trades at $22.70). For years they have been a dominant player in the propane equipment and services business. Recently, they diversified into the natural gas distribution market and the pulp chemicals business. One of their products is sodium chlorate, a chemical necessary in the bleaching of paper products. There are only a couple of companies in the world producing this chemical. The company is acquisition-minded and has a very successful track record of growing distributions and functioning as a successful trust. Last year they distributed $1.93 to unitholders. The current annual pace is $2.10, although they have a habit of adding special distributions in the spring. I’ve come across estimates as high as $2.35 in total distributions for next year. Too bad the payouts aren’t very tax friendly, but they sure look nice in the RRSP.

Now I’m headed back to the store that sells the rusty wheelbarrows. They have driveway sealer on clearance…$4 a bucket! Tar and me and driveway makes three.

The Market Guy is an Instructor with the Department of Psychology at Carleton University. He’s not a professional advisor. He’s just a guy who loves investing and talking about the markets. He recently listened to CIBC’s full-day conference on trusts. You can trust the day is always full atmail@marketguy.ca