An American dream — strong Canadian income trusts
Don’t be put off by the income trust tax, says America’s top expert on Canadian investments — smart investors can tap into a trust windfall.
When Mr. Jim Flaherty announced his distribution tax on income trusts back in 2006, the shock waves went well beyond Canada’s borders.
Cash-rich trusts from Canada had become a popular investment in the United States as well.
As we know, the trust market has proved remarkably resilient in the face of both looming taxes and a deteriorating economy.
But now, with the January 1, 2011 tax deadline drawing closer, investors on both sides of the border are trying to decide whether they should treat income trusts like red-hot potatoes or comfortable nest eggs.
Today we see what America’s foremost expert on Canadian income trusts is advising U.S. investors to do in the run-up to 2011.
Mr. Roger S. Conrad is not telling them to bail out — on the contrary. Writing in Personal Finance, he tells his readers that there is a windfall coming for those who pick the right income trusts. He picks six.
Stress tests
“Trust after trust,” says Mr. Conrad, “has faced down unprecedented stress tests, which peaked with last year’s market crash and subsequent global recession.”
In the wake of the large rally off the market’s low point on March 9, the average trust is still 30 per cent off its mid-2006 peak. Most trade at considerable discounts to book value despite secure double-digit yields.
On the other hand, debt is low, assets are growing and business is looking up for the best trusts.
“But many investors still believe that January 1, 2011 is doomsday for trusts,” he adds. “The result is a dark cloud of uncertainty hanging over even the sector’s strongest names.”
Mr. Conrad mentions the possibility that the Conservatives might be voted out before the trust tax takes effect, but that doesn’t really concern him. “Even if they aren’t, doom-fearing investors are in for a big surprise.”
Management takes action
The new tax just won’t hurt that much, this analyst insists. It will have “less of an impact than what’s baked into trusts. In fact, for some trusts it won’t affect dividends at all.”
Here’s proof, he says. 18 income trusts have converted to corporations. Most took price hits in the early days after conversion, but then snapped back to return more than 20 per cent from pre-conversion prices. Eight of them did it without cutting their distributions a penny.
In short, the best trusts aren’t waiting until the last minute to account for the consequences of 2011. They’ve done it already.
“Not every trust can sustain current dividend rates when the new tax kicks in,” Mr. Conrad concedes. “But the upshot is clear: Once management takes action to deal with 2011 taxes, share prices invariably rise. And most continue to pay high dividends to boot.”
Hedge against inflation
There is a lot to like about his six “windfall” trusts, Mr. Conrad says.
In addition to the trust-friendly points he has made above, there are two more advantages to these trusts, he tells his American readers.
One, none are energy producers, so volatile oil and gas prices won’t affect cash flow. Plus “all have low debt leverage and dividend coverage is strong. That girds them against any further economic downturn.”
Second, they are all priced and pay dividends in Canadian dollars. The loonie is closely aligned to oil prices due to Canada’s natural riches, he adds. Thus as energy prices rise, so will the U.S. dollar value of the dividends and share prices. That makes them a hedge against inflation.
The safest pick
One of Mr. Conrad’s six trust picks won’t be affected by the income trust tax at all. The units of Atlantic Power Corp. (TSX-ATP.UN; OTC-ATPWF) qualify as income participating securities, which combine a share of stock with a bond that matures in 2016.
The company owns a piece of 15 power plants as well as several other power projects. Atlantic’s management has affirmed the distribution rate for the next five years. Buy it up to US$10, says the analyst. It’s close, at $9.93.
The analyst calls Brookfield Renewable Power Fund (TSX-BRC.UN; OTC-BRPFF) “the safest pick on our list.” It should also be the first to go corporate. Its partner, Brookfield Asset Management (TSX-BAM.A; NYSE-BAM) has put all of its renewable energy assets into the trust. It now has 1,600 megawatts of hydroelectric and wind power capacity.
Management has pledged to maintain the distribution rate well past 2011. And it’s liable to rise further, says the analyst. Buy it up to US$17, he advises. To do so, investors will have to wait for it to fall. It’s at $23.
Pipeline giant Pembina Pipeline Income Fund (TSX-PIF.UN; OTC-PMBIF) has also assured investors it will maintain its current distribution for at least five years. Since it earns fees based on capacity, it doesn’t rely on oil prices to prosper. A buy under $US16, it’s at $14.82.
In prime condition
Yellow Pages Income Fund (TSX-YLO.UN; OTC-YLWPF) ran into a slump that threatened its ability to outgrow the 2011 tax. Now, however, “management has made good on its pledge to stabilize the business,” says Mr. Conrad. Costs are down, sales are up and the company has confirmed the current distribution beyond 2011.
With a yield of 14 per cent, it’s a buy under US$7 and trades at $5.35.
Two lesser-known trusts round out this six-pack. Bird Construction Income Fund (TSX-BDT.UN; OTC-BIRDF) and Chemtrade Logistics Income Fund (TSX-CHE.UN; OTC-CGIFF) “are in prime condition to maintain their current distributions, tax or no tax.”
Bird raised its payout in May and is “nailing down government-financed construction projects,” says the analyst. Buy it under US$30, he says. It has jumped above that price, at $33.
Specialty chemicals maker Chemtrade is the one trust on the list most subject to economic ups and downs, the analyst admits. “Management’s exceptionally conservative financial policies, however, have kept the distribution well-covered despite one of the worst markets in memory.”
But it up to US$9, he says. It’s just above that, at $9.55.
The prices of these income trusts have all risen (in some cases sharply) in the short time since this article was published.
Which simply proves that many investors agree income trusts aren’t headed for a pratfall, but a windfall.
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