Income trusts: Stick with high quality

These are difficult times for income-seeking investors. Bonds yield around half of what they did 10 years ago, yet more and more investors are nearing retirement, when many pay close attention to investment income. Many also see income as a sign of investment quality. These factors have kept up investor interest in income trusts.

Despite Ottawa’s plan to start taxing trust distributions in 2011, income trusts should continue to pay above-average yields for years to come. Unfortunately, however, high current yields on the majority of trusts obscure their drawbacks.

Income seekers may mistakenly assume that yearly distributions on income trusts will hold steady, like interest on a bond, or rise, like dividends on a stock. But, in the long term, many trust distributions are apt to dwindle, or abruptly halt. That’s because many trusts own so-called “cash cow” businesses. These are businesses that can be milked for their cash flow for many years, but are likely to stagnate or stumble as the economy changes and competition grows.

Other income trusts borrowed to invest in cyclical industries. When the cycle turns downward, as it is now, profits and cash flow will evaporate overnight.

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An added risk is that many trusts are still relatively new to the market, so they expose you to new-issue risk. As we’ve often pointed out, new issues come to market when it’s a good time for insiders and/or the company to sell. But that may not be, and often isn’t, a good time for you to buy.

Although unit prices on income trusts have dropped lately, we see no great wealth of opportunity in this market segment. We still advise you to confine your trust holdings to issues we recommend, and to limit your trust holdings to 15% or less of your portfolio.

Still, we continue to comb through the income trusts on the market, looking for value. From time to time, we come across attractive and highly profitable choices.

These include, for example, high-quality oil and gas income trusts that will continue to show strong cash flow and production, even at lower oil and gas prices. It would be a mistake to bet too heavily on oil and gas price predictions, since both will remain volatile, so you shouldn’t overindulge in these trusts. We also think you should view them as part of the resources segment of your portfolio, rather than as fixed-income investments. But, overall, we believe the best of the oil and gas income trusts are well-positioned for low-risk returns.

The best of the real estate investment trusts, or REITs, have good management and balance sheets strong enough to weather a long economic downturn. They also have high-quality tenants, and they carefully match their debt obligations with income from their leases. The best ones are still doing well, despite the economic slowdown, and are taking advantage of low interest rates to refinance long-term mortgages.

We still advise against overindulging in REITs. But if you stick with high quality REITs, like the ones we recommend, they can make attractive, low-risk additions to your portfolio.

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