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A happy Halloween story — income trusts live on

One of Canada’s top advisers on income investing says income trusts will survive because high-yield investments are in demand.

Since the income trust tax will be a year old on Halloween, maybe we should treat trusts in a seasonal fashion. As zombies, or vampires. The undead. The government hasn’t driven a stake through their collective hearts yet, etc., etc.

But why be any scarier than we need to be? Despite the carnage that occurred in the trust market after the tax, income trusts are still with us. And they will be with us for some time to come, in the opinion of one of Canada’s foremost analysts of the income investment scene.

“Trusts Will Survive!” announces Mr. Gordon Pape in his headline in The Income Investor. And not just until the tax comes into effect in 2011, either.

To put it another way, Canadians like high-yield investments, so high-yield investments are here to stay.

A grain of salt

There is no point in wishing the income trust tax away, says Mr. Pape. Unless something dramatic happens, it will go into law on January 1, 2011.

“It appears the only way that will change is if the Liberals are returned to power before then,” says Mr. Pape. Given the current disarray of the party, its low standing in the polls and the fact that it is broke, that hardly seems likely.

“And even if the Liberals did pull off an upset, would they keep their promise to cut the tax rate to 10% (from 31.5%) and make it refundable to Canadians? Given what happened with the Conservatives and the past history of the Liberals on the trust file, we should take all such pledges with a grain of salt.” Mr. Pape gives the repeal of the tax no more than a ten-to-one chance.

The trust sector has already begun the process of winding down. The general expectation is that few will be left when the tax kicks in. Not so fast, cautions Mr. Pape.

A new type of security

“Some money managers are coming around to the idea that more trusts than expected may survive and that we are about to see the birth of a new type of security, the high income corporation,” says Mr. Pape.

He quotes Mr. Paul Bloom, manager of several closed-end funds for Citadel Investments. “Canadians have proven they need and want high-yield securities,” says Mr. Bloom. “Demographics are going to continue to drive that need.”

Bay Street’s financial engineers are “remarkably creative” in meeting such needs, adds Mr. Pape. Just look at the clone funds, income trusts, principal protected notes, mutual fund T units and other new investments that have sprung up in recent years.

“High-yield corporate stocks don’t appear to be too much of a stretch in that context,” he concludes.

In fact, they are already making their appearance. One is Student Transportation of America (TSX-STB), which is in the process of converting from an income participating security (a common share and a high-yield bond fused together) to a high-yield common stock.

Also in the vanguard of the movement is Northstar Healthcare (TSX-NHC). The company went public on May 17 at $12.25 a share. It owns and/or manages ambulatory surgery centers, with its initial focus on Houston and other metropolitan areas in Texas. With a 10¢ per share monthly dividend, the stock initially yielded 9.8 per cent. The share price has shot up to $19.10 and the yield has dropped to 6.3 per cent.

“The Northstar success, and the positive investor reaction during a time of market turbulence has not gone unnoticed,” Mr. Pape tells his readers in the Income Investor. “It’s highly likely that a number of similar deals are in the pipeline.”

Yet even though high-yield corporations are bound to play a greater role in the high yield sweepstakes, income trusts will still be around. That is the opinion of Mr. Bloom, who has spoken to more than 150 trust CEOs. All of them say they intend to continue under the trust status or convert to a corporation with a high-yielding common stock.

Three reasons for survival

Mr. Bloom offers three reasons why income trusts will survive.

First, don’t forget about the dividend tax credit. It will serve as a boon for those who hold trusts in taxable accounts. Starting in 2011, income trust distributions will be eligible for the dividend tax credit, which should just about offset the impact of the trust tax. The big losers will be investors who hold income trusts in registered plans, or U.S. investors, who don’t benefit from the dividend credit.

Second, there are a number of income trusts holding large tax pools. These will protect part of their distributions as far into the future as 2015 or 2016. Some are implementing corporate reorganizations to take maximum advantage of this situation. One trust in this fortunate position is oil and gas services trust Keyera Facilities Income Fund (TSX-KEY.UN; OTC-KEYUF).

Third, some trusts are gradually lowering their payout ratios with an eye to the future. They are not raising their payouts even when distributable cash increases. If they can bring their payout ratios down to the 60 per cent range over the next three years, they will be able to maintain their current distribution levels even after the tax comes into effect.

One of the few trusts Mr. Bloom is buying now, by the way, is Kenyara Facilities. He also likes two other income trusts that Mr. Pape has recommended in The Income Investor, transportation specialist TransForce Income Fund (TSX-TIF.UN; OTC-TIFUF) and oil patch veteran Precision Drilling Trust (TSX-PD.UN; NYSE-PDS).

The current situation is obviously very fluid, concludes Mr. Pape. “We’re in a transition stage that will take a couple of years to play out. But one things appears certain: by the time 2011 rolls around, cash-hungry income investors may have many more choices than they expected.”

In a word, more treats than tricks.