Income Trust: An Investment That’s Too Good to be True?

In recent years, a creative new form of financial instrument has become all the rage in Canada (it has not caught on, to my understanding, in other countries, though the US does have a similar more narrowly-defined security called a Real Estate Investment Trust). It’s call the Income Trust (or Income Fund), and it’s a form of high-yielding equity, filling the ‘gap’ between today’s overpriced, low-yielding common stocks and moribund, equally low-yielding bonds. They’re so popular that when a Canadian oil company announced today it would convert all its shares to Income Trust units, the stock jumped 15% on the news. There are several hundred Income Trusts traded on Canadian stock exchanges, and Income Trusts now constitute the majority of new Canadian initial public offerings.

I am not an investment advisor and the information below is what I have gleaned from some confusing and sometimes contradictory information on a variety of Canadian websites.

The tricky part about Income Trusts is the huge variation in terms and conditions, but let’s start by looking at what just about all Income Trusts have in common:

They are issued at a price to yield generally 7-10% before tax; however, this yield depends on the Income Trust’s cash flow and is not guaranteed
They are secured by assets that have a long life (real estate, pipelines etc.) and which yield a significant realtively steady annual cash flow (from rents, royalties etc.)
To the extent these assets depreciate, that proportion of the annual trust income is treated by the unit-holder as a return on capital, subject to a lower tax rate
Because all the ‘income’ of the Income Trust is paid out as an ‘expense’ to unit-holders, the Income Trust has no ‘net income’ and hence (under current Canadian tax law anyway) pays no corporate tax
As long as interest rates remain low, Income Trusts are attractive at 7-10% yield rates, but if interest rates suddenly spike, the price of Income Trusts should be expected to plunge to the point their (un-guaranteed) yield exceeds the yield of (guaranteed) bonds, T-bills and investment certificates

Now some of the differences:

Since the assets of the Income Trust can be seen as ‘wasting’ rather than appreciating, some Income Trusts have a guaranteed buy-back price equal to the initial issue price; this would protect the investor in the case of an interest rate spike, but it too has some tax consequences — a portion of the buy-back price, when you receive it, is taxed as a capital gain
Some Income Trusts are much riskier and carry yields as high as 20%; they are generally fixed-life trusts and when the assets are fully depreciated or depleted, you just have to hope the projections were right and you’ve already recouped your investment
There is now a second type of Income Trust called financial Income Trusts that are actually a completely different type of financial instrument; they buy a basket of stocks in other companies, usually those that are quite price-volatile, and sell call options on them (the call option allows the buyer to limit the amount of loss — and gain — on these volatile stocks, to moderate the risk); the income from the call options provides a steady cash flow that is paid out to the Income Trust’s unit-holders just as in any other Income Trust, though the tax consequences can be quite complicated — but the advantage is that this type of Income Trust will rise rather than fall when interest rates jump, and it is only vulnerable to periods of significant stability in the stock market (which lower the value of call options and hence squeeze the Income Trust’s cash flow; so some investors are buying a mix of both types of Income Trust, hedging one against the other

So if you’re living on a fixed income, you may be drawn to the 7-10% return that Income Trusts offer, even though that return is not guaranteed (the issuer’s reputation is at stake, and some investors figure that if the economy gets bad enough that companies have to sacrifice their reputation by reducing their Income Trust’s yield, other equities and bonds will probably be in the tank as well). And some Income Trusts do guarantee to pay you back your ‘principal’ investment, so if you have these you can cash out and reinvest in high interest T-bills when the next stagflation/depression hits.

But there are other risks besides the lack of guaranteed yield, If the assets are in real estate or some other industry where the bubble bursts, the ‘steady cash flow’ may suddenly dry up. The current tax treatment of these investments is under review in Canada. And some Income Trusts don’t yet have the limited liability protection of common shares (though that is coming).

As with any investment, you have to read the fine print to understand all the terms and conditions. As they say “the projected life of distributions and the sustainability of distribution levels tend to vary with the nature of the business underlying the income trust”. In the meantime, a lot of people desperate for a reasonable return on retirement savings and terrified by overpriced stock markets and overheated real estate markets are betting heavily on Income Trusts, sometimes perhaps with insufficient information to do so wisely. But in the short run, this is the market’s way of filling an urgent need in a low-interest-rate, high P/E, volatile financial market.

The real mystery to me is why Income Trusts haven’t caught on in other countries.

(Full Disclosure Statement: I am a relative of the owners of Pollard Banknote, a company in Winnipeg that has just successfully completed an Income Trust public offering. I have however no personal financial interest in the company.)