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Prospects dimmer for income trust funds

After a stellar 2001, managers downplay investor expectations for 2002

Special to The Globe and Mail

Canadian income trust funds were one of the best places to be in 2001. Thanks to a backdrop of low interest rates and strong energy prices in the first half, the funds gained an average of 11.1 per cent last year -- vastly ahead of the Toronto Stock Exchange 300 total return's 13.9-per-cent loss.

But prospects for 2002 are not nearly as bright.

Interest rate-sensitive real-estate investment trusts (REITs), which form the bulwark of many funds, will feel the impact of rates creeping up as the economy improves.

And energy prices, which have weakened significantly because of a global slowdown, could take some time to recover.

As a result, most fund managers are downplaying investor expectations in 2002 and calling for "coupon-like" returns of about 8 to 10 per cent.

That's a far cry from last year, when investors typically received high single-digit capital gains on top of monthly income distributions.

"I've been telling unitholders, 'It won't be easy, but we can still get about 8 per cent in 2002,' " says Ben Cheng, vice-president at Toronto-based CI Funds Signature Group and manager of the $383.9-million CI Signature High Income Fund, which returned 15 per cent in 2001 and 1.6 per cent year to date. "Investors did very well last year, but the environment is not the same."

Much depends on the direction of interest rates. If they stay where they are, Mr. Cheng believes REITs could earn about 8 per cent. But if the economy strengthens, interest rates could trend up and make REITs relatively less attractive.

Moreover, Mr. Cheng notes that real estate is a lagging asset class and performs well at the end of an economic cycle.

"Even though the economy will do better in 2002, real estate will lag that recovery."

Prospects for income trusts -- an asset class that is comprised of slow-growth businesses such as cold storage, as well as power utilities and oil and gas royalty trusts -- are mixed. Mr. Cheng believes the first category should be stable and return around 10 per cent, but utilities are highly sensitive to interest rates and may see low single-digit returns.

Energy trusts have the best prospects, in his view, but are also the riskiest of assets. "We expect that crude oil will average $20 to $22 (U.S.) a barrel," he says. Assuming that forecast holds, these trusts could earn around 13 to 18 per cent. Last year, the steep decline in energy prices saw trusts return around 10 per cent.

But a stronger economy will help some trusts, says Leslie Lundquist, vice-president at Calgary-based Bissett Investment Management and manager of the $39.1-million Bissett Income (F) Fund, which returned 22.4 per cent last year and 0.4 per cent year to date. "Some trusts that have been hurt by economic weakness will start to recover," she says.

Pointing to Simmons mattress-maker SCI Income Trust, for example, Ms. Lundquist says, "in 2002, it should start to recover, assuming the economy picks up."

She notes that some hotel REITs have started to rebound, after tumbling in the aftermath of the Sept. 11 terrorist attacks. "We've already seen some recovery in prices. In 2002, we should see a gradual recovery in distributions as well."

But she concedes that the outlook for energy trusts is murky. "It's a tough call," says Ms. Lundquist. "We will see much lower distributions in 2002. But I'm not sure how the prices of the trusts will react. There could be a lag effect. I'm not saying energy is a bad investment, but I sure wouldn't be running whole hog into that sector."

How are managers playing their funds?

Ms. Lundquist is being cautious and has reduced the oil and gas trusts to 14 per cent of her fund from 20 per cent in June of last year. Currently, she still likes Enerplus Resources and Canadian Oil Sands Trust.

There is also about 28 per cent in REITs. "It looks as if we are having a fairly mild downturn, and it is showing in their prices. They have held up extraordinarily well. Even the hotel REITs came back quite nicely," says Ms. Lundquist, adding that she owns Canadian REIT, Legacy Hotels REIT and RioCan REIT.

Another 55 per cent of the fund is held in a variety of other sectors. Ms. Lundquist likes SCI Income Trust, Atlas Cold Storage Income Trust and Pembina Pipeline Income Fund. The remainder is held in cash.

Alan Wicks, manager of the $138.9-million Elliott & Page Monthly High Income Fund, which returned 18.4 per cent last year and 2.1 per cent year-to-date,is also playing it safe.

"We've had the wind at our backs, in the form of falling rates, but now we've turned the boat around. We will have to do some tacking to get where we want to go," says Mr. Wicks, a portfolio manager at Toronto-based Elliott & Page Investment Counsellors.

Mr. Wicks' biggest strategic shift has been to reduce the oil and gas trusts' exposure to around 8.5 per cent, compared to 22 per cent last summer. He has also increased non-energy trusts as well.

"I'm trying to generate the higher yield from the non-energy trusts, without the commodity exposure. I am not sure what is going to happen to commodity prices."

Striving for consistent, tax-efficient income while preserving capital, Mr. Wicks has also invested about 18 per cent in REITs, 20 per cent in dividend-paying common stocks such as Power Corp., 14 per cent in government bonds, 35 per cent in a mix of utilities and industrial income trusts and 4.5 per cent in cash.

For his part, Mr. Cheng has 35 per cent in income trusts, 20 per cent in REITs, 35 per cent in high-yield corporate bonds, 5 per cent in preferred shares and the rest in cash.

Recently, he's become more aggressive and raised the energy-trusts exposure to 12 per cent from 10 per cent at the start of the year. "A lot of oil and gas trusts' prices dropped 25 to 30 per cent. They now represent better value."

ARC Energy Trust, Enerplus Resources Fund and Canadian Oil Sands Income Trust are among his favourite names. "These trusts have the least sensitivity to interest rates. If the economy strengthens, it will drive oil and gas prices higher."

Mr. Cheng also reduced his REITs exposure in the fourth quarter of last year to 20 per cent from about 33 per cent because yields have fallen to about 8 per cent and spreads (the differential over government bonds) had fallen by half to 2.5 percentage points. In short, the risk-reward ratio for holding REITs is less attractive, he says. "You're not getting paid to be there."

The balance of the fund is in corporate bonds, from issuers such as Sobeys Inc., and Oxford Properties Group Inc.

How should investors approach this sector? Fund watchers like author Gordon Pape warn investors to tread carefully and focus on funds with a healthy income stream.

"A true fund will have a large percentage of income trusts and REITs," says Mr. Pape. "Their purpose is not total return but above-average, tax-advantaged cash flow. Their success should be measured by the degree to which they do that."

His second caution is that many funds are volatile and total returns can be negative. That's what happened in 1998, for example, when oil and gas trusts crashed because of plummeting commodity prices and the average fund lost 3.6 per cent. While investors continued to receive income, Mr. Pape notes, they were unhappy that unit values fell.

"Just remember why you buy into them: you're looking for tax-advantaged income," he says.

Dan Hallett, senior fund analyst at Windsor, Ont.-based Sterling Mutuals Inc., also urges caution.

"They can be used to generate a fairly high income, but, from a risk standpoint, they should be treated like equity securities," he says, recalling poor years such as 1998.

He says 8- to 10-per-cent annual returns are more realistic.

© 2007 The Globe and Mail. All rights reserved.

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