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Income Trusts: Stick With High Quality Only

These are difficult times for income-seeking investors. Bonds yield around half of what they did 10 years ago. Yet more and more investors have reached an age when they pay close attention to investment income, to pay for retirement or because they see income as a sign of investment quality. This has renewed investor interest in income trusts.

Despite Ottawa’s plans to start taxing trust distributions in 2011, they 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 assume that yearly distributions on income trusts are likely to hold steady like interest on a bond, or rise like dividends on a stock. But in the long term, all too many trust distributions are more apt to dwindle or halt abruptly. That’s because many trusts own so-called ‘cash cow’ businesses. These are businesses that can be milked for their cash flow for years to come, but that 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 in these acquisitions, as it is now, profits and cash flow will disappear overnight.

An added risk in many trusts is that they are still relatively new to the market, so they still 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 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 also be a mistake to bet too heavily on oil and gas price predictions, since both will remain volatile. So you shouldn’t overindulge in them. As well, view them as part of the resources segment of your portfolio, rather than as fixed-income investments. But overall, 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 with their leases. The best ones are also still doing well right now, in spite of the economic slowdown. They are also taking advantage of low rates to refinance long-term mortgages.

Again, we advise against overindulging in REITs. But if you stick with the highest quality, like the REITs we recommend, you should make attractive long-term returns with low risk.

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