Income trusts powered a wide variety of mutual funds to some outstanding gains in the past few years, but that's ancient history.
Today, with the federal government cracking down on the trust sector, investors who hold funds loaded with trusts have to wonder whether it's time to move on. For some investors, the answer is a definite yes.
These would be the people who bought funds in the income trust or diversified income category for the total returns they provided -- cash distributions plus capital gains or, in other words, gains in the fund's unit price. You're in this category if you own an income trust fund and are having your cash distributions reinvested rather than taking them in cash.
Dave Paterson, an independent mutual fund analyst, said trusts are unlikely to produce significant capital gains as we head toward the 2011 introduction of a new tax on trust distributions. "If you're looking for capital gains, you're better off in a well diversified dividend-type fund," said Mr. Paterson, who provides research to investment advisers through his firm, Dave Paterson & Associates.
Dividend stocks don't provide anywhere near the same yields as trusts, but they offer the potential for excellent long-term capital gains. As it happens, many blue-chip dividend stocks have moved up in price since the Oct. 31 announcement of the new trust tax.
If income was your primary reason for buying a fund heavily invested in trusts, then there's a good argument for staying put and not selling. While income trusts have fallen in price, sometimes sharply, they're still delivering the same monthly or quarterly cash distributions that they were prior to Oct. 31. Moreover, trusts have four years to go until the new trust tax kicks in.
"If you're looking for income, income trust funds are still going to be able to offer the same yields, or even slightly higher yields, than they have historically," Mr. Paterson said.
Higher yields? Correct. With fund unit prices down because of the downturn in the broad trust market and distributions remaining steady, yields have risen a bit. Unfortunately, higher yields have come hand-in-hand with increased volatility in the trust market, which means more ups and downs for funds that own lots of trusts.
If you're tightly focused on wringing income out of your investments and can stand some volatility, then price swings may not matter.
But what if you're someone who is bugged by big moves in the value of your funds from monthly statement to statement? In this case, Mr. Paterson suggests a diversified income fund that blends trusts with bonds and dividend-paying common and preferred shares into a package with less volatility than a fund 100-per-cent invested in trusts.
An example of this sort of diversified fund is Inhance Monthly Income, which is run by Inhance Investment Management, a Vancouver firm that specializes in socially responsible investing. Portfolio manager Steve MacInnes said the fund now has a little over half of its assets in trusts, a little over one-third in bonds and the rest in dividend-paying common and preferred shares.
Mr. MacInnes, for one, is optimistic about trusts. "We're accumulating income trusts again," he said. "We want to raise our holdings to a higher level, which might be in the high 50-per-cent level or even 60 per cent, and then maintain that level. We're of the opinion that the trust market is going to stay around."
The key question for unitholders of a fund like Inhance Monthly Income is how secure the monthly cash distributions are. Mr. MacInnes doesn't see any problem between now and 2011, when the new trust tax begins to cut into the amount of distributable cash that trusts have. The flow of cash beyond 2011 is another matter.
"I suspect, on balance, that there will be some drop-off," he said.
"But four years is a long time -- the economy will grow, companies will acquire things or grow internally. You may not end up seeing much of a hit."
Investors who own income trusts through closed-end funds listed on the Toronto Stock Exchange have an especially tough decision to make about whether to hold or sell. Closed-end funds are run pretty much like mutual funds, but they're permitted to invest more aggressively by using borrowed money, or leverage.
Leverage can help increase gains beyond what the market produces, but it can also cause worse-than-market losses. This is exactly what has happened with some, though not all, closed-end income trust funds. Heavy exposure to hard-hit energy trusts is another factor weighing on some closed-end funds.
While unit-price volatility can be distressing, the real issue for income-seeking investors is whether they're getting the cash they need every month. Closed-end funds continue to deliver on this count.
If you do decide to get out of a closed-end fund, remember to use a provision that allows these products to be redeemed at net asset value once per year.
These funds usually trade at a discount to net asset value, so selling on the spur of the moment can net you less than you could otherwise get.
© 2007 The Globe and Mail. All rights reserved.
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