Editor’s note: A later article discusses Canadian REITs in more detail.
I spend my days and nights reading up on, thinking about, analyzing—and visiting—Canadian income trusts. They are my life. I think I understand them better than anyone in the
— Roger Conrad, Canadian Edge
A couple weeks ago, I wrote about master limited partnerships (MLPs) and their high cash distribution yields. In fact, the average annual yield of the Alerian MLP Index (NYSE: ^AMZ) is 6.62%. At the time, I thought you couldn’t find a higher-yielding group of equities.
I was wrong.
Don’t get me wrong, MLPs are great high-yield investments that have the added kicker of a tax-deferral feature, making them ideal for taxable accounts.
But up in the Great White North –
Background of Canadian Income Trusts
Canadian income trusts are similar to U.S. MLPs; in fact, they were inspired by them. The first income trust came into existence in 1985 and was the Enerplus Resources Fund (NYSE: ERF). There are three main types: (1) oil & natural gas production; (2) power and pipeline; (3) real estate investment trusts (REITs); and (4) general business. According to Bloomberg, more than half (53%) of the approximately 200 Canadian income trusts are of the oil & gas production variety.
Revenue from oil & gas production is highly susceptible to volatile energy prices, and thus could be considered more risky than the steadier, more reliable cash flows of other types of businesses like pipelines. This may partially explain why Canadian income trusts pay on average higher yields than U.S. MLPs, which focus more on pipelines than production. The main reason for the higher yields of income trusts, however, is the irrational fear over an upcoming change in their tax treatment (described below). But first, let me describe their current tax treatment.
Current Tax Treatment of Canadian Income Trusts
Like U.S. MLPs, Canadian income trusts are pass-through entities that don’t get taxed at the entity level but only at the investor level. By avoiding the double-taxation inherent in regular corporations, income trusts can distribute more cash to unit holders. Also like U.S. MLPs, a portion of their cash distributions are often considered a “return of capital” which is tax-deferred until the units are sold. I’m no expert on Canadian tax law, but I think that the return-of-capital portion of income trust distributions is a lower percentage than the typical 80%-90% portion of U.S. MLP distributions. Furthermore, whereas all U.S. MLPs are partnerships that issue K-1 tax forms (which can be irritating), many (but not all) income trusts are considered corporations for U.S. tax law purposes and issue the regular 1099 tax forms.
Tax Treatment is Changing on January 1, 2011
Back on October 31, 2006, the Canadian government shocked the investing world by announcing that all Canadian income trusts (except Canadian REITs) would lose their tax-advantaged status and be taxed at the entity level — just like corporations — starting in 2011. This tax change was labeled “The Halloween Massacre” because within two weeks of the announcement, the Canadian income trust index plunged 17.8%. This was a wild overreaction, however, based on bad analysis. As KCI’s Roger Conrad, editor of Canadian Edge has explained:
Some “analysts” worked up formulas showing US investors being directly assessed an additional 31.5 percent tax to the 15 percent withholding already in place, for assessments of over 40 percent.
Were that true, no sane individual would have purchased Canadian trusts. Fortunately, such calculations were utter fantasy. Unfortunately, such falsehoods were a big part of the selling panic that gripped trusts in November 2006, as well as the black cloud that’s hung over these investments ever since. And they continue to sow confusion in the marketplace today.
In fact, as is the case in most countries, Canadian corporations on average pay an effective tax rate of less than 10 percent of income, thanks to a wide range of deductions, from depreciation to goodwill. Those advantages will also be available to converting trusts.
Tax Increase Will Be Modest
So, while taxes will be going up for many Canadian income trusts, they will on average be going up less than 10 percent. The best income trusts are so well run that they can absorb that additional tax without cutting cash distributions to unit holders. In fact, 31 income trusts have actually decided to convert to corporations early (i.e., before 2011) even though it requires them to pay more tax. They wouldn’t have done this if their tax burden was increasing substantially. One of the main reasons trusts decide to convert early is that under Canadian law trusts are severely restricted from issuing new shares whereas corporations have complete flexibility.
Cut-less Conversions Are Increasing in Frequency
According to Roger Conrad, of the 27 income trusts that have converted to corporations and paid distributions prior to converting, one-third have announced that their distributions will not be cut. Even better, of the 33 trusts that have announced but not completed conversions, 23 have announced they won’t cut distributions at all, and two have actually said that they will increase their distributions!
Does this sound like Armageddon? Not even close, yet most investors continue to avoid income trusts out of irrational “conversion fear.” This fear has caused the prices of income trusts to remain incredibly cheap – much cheaper than justified by their strong cash flows and high yields.
Now is the Time to Buy Canadian Income Trusts
To see this, just look at the performance of the 31 income trusts that have converted early: their average return has been an astounding 45.3% since their conversion announcement! As Roger Conrad has written, those investors who buy these trusts now – before the January 1, 2011 conversion deadline — will not only benefit from their high yields, but the capital appreciation “kick” that will occur when investors finally realize that conversion is no big deal:
We may have to wait until 2011 before the taxation fears bedeviling trusts since Halloween 2006 finally go away. But when they do, today’s low valuations will be only a memory. That means strong gains in addition to high yields for those who buy in now. Latecomers, however, will have to settle for less.
The post-conversion appreciation “kick” has been so intense because most of the trusts still remaining are the strongest of the strong. In his award-winning advisory Canadian Edge, Roger Conrad actually has some good things to say about the 2006 Halloween Massacre because it forced fiscal discipline on the income trust universe. According the Roger, the Massacre “established a four-year stress-test that’s left us with the best high-yielding securities on the planet.” Only those trusts that have solid businesses and strict cost controls are able to continue to attract investment dollars and provide high cash distributions despite the impending tax change:
We are in fact witnessing the birth of a new breed of company–as trusts converting to corporations offer both robust growth and high income thanks to unmatched discipline. Although those extreme values are certain to disappear eventually as investors come to appreciate them, we now have a superb opportunity to buy them cheaply and ensure superb wealth-building for years to come.
Retirement Accounts Will See Automatic 17.6% Dividend Boost in 2011
And there’s an added bonus to conversion for those investors who hold Canadian income trusts in retirement accounts (e.g., IRAs and 401ks). The Canada-U.S. tax treaty exempts dividends accrued in retirement accounts from tax withholding. In
But once income trusts convert to corporations, their cash distributions will be considered “dividends” that are exempt from Canadian tax withholding in retirement accounts. This means that the 85% of an income trust’s distributions a
Proprietary Safety Ratings Make the Difference
Of course, not all Canadian income trusts are worth investing in. One needs to perform exacting and hard-core analysis to find the real winners. And that type of expert analysis is not easy to perform, which is why Roger Conrad’s Canadian Edge investment advisory is such a value. Roger has devised an ingenious six-point rating system for income trusts that measures how safe and sustainable their cash distributions are. Companies are rated on a scale of 0 (riskiest) to 6 (safest) based on several criteria intended to gauge sustainability of distributions. The rating is based on how many of the following criteria are met:
- One point if the payout ratio meets “very safe” criteria for the sector.
- One point if the payout ratio is not “at risk” based on the criteria for its sector.
- One point if the debt-to-assets ratio meets “very safe” criteria for the sector.
- One point if company is already organized as a corporation, a qualifying REIT (no change to tax status in 2011) or has clarified its dividend policy for when it converts to a corporation.
- One point if the company’s primary business is recession resistant. Qualifying varies from company to company, though virtually all electric power and energy Infrastructure companies qualify, while no energy services companies do.
- One point if the company’s profitability isn’t directly affected by changes in commodity prices.
You can’t find these safety ratings anywhere else! Roger rates the safety of all of the approximately 200 income trusts in existence, along with buy/sell recommendations that include additional valuation criteria. But he has isolated only the 33 “best of the best” income trusts to include in his Canadian Edge recommended portfolios – 12 in the “Aggressive” portfolio and 21 in the “Conservative” portfolio.
Looking over the list, I count ten “buy” recommendations in the Conservative portfolio that have earned the top safety rating of 6. Two of them sport annual yields of 11.8% and 10.9% respectively. Near-perfect safety and double-digit yields? You can’t beat that.
Which are Better,
MLPs or Canadian Income Trusts? U.S.
They’re both excellent high-yielding investments and both deserve a place in your portfolio. Personally, I put MLPs in my taxable account and Canadian income trusts in my retirement account. The bottom line is that U.S. MLPs outperform Canadian income trusts when the U.S. dollar is strengthening and income trusts outperform MLPs when the Canadian dollar is strengthening. For diversification purposes, it makes sense to own both types of investments so that you can benefit from U.S.-Canada exchange rate movements in either direction.
Exposure to the Canadian Dollar is a Good Thing
One of the great things about Canadian income trusts for
Give Canadian Edge a Try –You Won’t Regret it
Are you ready to relax into a steady, monthly stream of dividend checks, plus the promise of lip-smacking capital appreciation? With the S&P/TSX Capped Income Trust Index currently yielding 7.65%, now is a great time to add some Canadian income trusts to your portfolio, especially your tax-free retirement portfolio.
Only one market—