Relative to other high-yielding sectors, damage to trusts has been comparatively mild. The S&P Toronto Stock Exchange Trust Index is still within a few points of the highs it reached in early June, when the broad-based average actually closed above pre-Halloween levels. And we’re still seeing some big gains from takeovers as private capital continues to circle in.

Moreover, oil prices and the Canadian dollar have returned to the upside. The loonie is rapidly closing in on parity with the US dollar, though with more than the usual daily volatility.

As for 2011 taxation of trusts, that’s now the law with the passage of the Conservative Party budget. But with the Liberal Party campaigning on reducing the prospective maximum tax from 31.5 percent to just 10 percent—and ahead in many polls leading up to the as-yet unannounced election—even that remains a wild card.

In uncertain times like these when there are so many hypotheticals, it’s critical to go back to what we know. First, the market is now pricing in the full impact of 2011 taxation, just as it has been since mid-November of last year. That point was made clear by the relative lack of movement following the final passage of the budget last month.

Second, if there’s any change to the tax rate—whether from a Liberal victory or a Conservative government change of heart—the result will almost surely be a major upswing for trusts. Equally, however, there are just too many ifs for anyone to base a strategy on such an outcome.

Rather, the 2011 tax is law, and everyone should proceed as though it will remain in place. That’s, in fact, what trust managements are doing now. The good news is, with the market already pricing in the tax increase, there’s no further risk to holding trusts well beyond 2011, at least on that score.

Third, with three more deals announced this month, private capital’s foray into trusts continues. The keys are buyers’ interest in trusts’ abundant cash flow and managements’ willingness to sell at the right price. As long as these factors are in place, we’ll see more buyouts at good premiums.

As for energy prices, until we see the four factors that ended the bull market of 1970s, they’re going to remain strong. That’s real conservation on the scale of the previous generation’s switch to small cars, a move to alternative energy on par with the ’70s mass opening of nuclear power plants, a major discovery of conventional reserves at least equivalent to what the North Sea was in the ’70s and very likely a global recession.

Oil and gas certainly had their ups and downs in the ’70s. But only those four factors together changed the balance of power from energy producers to consumers and thus ended the bull market. And despite some adoption of hybrid cars, promotion of biofuels, wind and nuclear power and ramping up of oil sands and deepwater drilling, we’re no where close to a ’70s-magnitude shift.

Near-term oil and gas prices will continue responding to the weekly inventory numbers, which are heavily influenced by weather. Gas, for example, is weak here in early July, in part because the scorching spring in the Northeast has abated a bit with the arrival of summer, resulting in building inventories.

Gas’ long-run fundamentals, however, have scarcely dimmed. In fact, demand is set to take a quantum leap forward as US utilities are required to meet carbon emission restrictions in coming years.

Energy’s not the only industry in Canada. In fact, the fortunes of the Conservative Portfolio trusts (see below) are largely independent of its fluctuations. But energy is the straw that stirs the drink for our northern neighbor. And as long as it’s strong, Canada’s economy, investment markets, property market and currency will keep moving higher. That goes for well-run Canadian trusts as well.

US interest-rate volatility is another matter. But given the yield advantage trusts enjoy over other income investment sectors, it’s no wonder the damage has been muted relative to, say, US utilities or REITs. In fact, the energy patch actually has the ability to move counter-cyclically against another US rate spike as long as oil and gas prices remain strong. They’re likely to prove a valuable hedge for income investors in what could be tough times this summer.

In Our Control

One thing that all of the above factors have in common is that they’re beyond our control. There’s certainly plenty to be bullish about in the next several years. But ultimately how our trusts perform will depend on a factor very much within their control and ours as investors: That’s how they perform as businesses.

At Canadian Edge, we focus on the external factors. The politics of trust taxation, for example, have been a recurring theme in the Maple Leaf Memo, a complimentary weekly update service available to CE readers by going to www.mapleleafmemo.com. They’re also the subject of this issue’s Canadian Currents article.

Our main goal is to exhaustively assess the business prospects of all of the trusts we cover in How They Rate and decant the best into the Canadian Edge Portfolio and as other recommendations. That means looking carefully at the numbers, as we did in the June issue following the release of first quarter earnings.

It also means keeping tabs on major developments at each trust that are likely to affect future performance, including acquisitions and asset dispositions, strategic announcements, distribution increases, executive changes and regulatory developments. The result isn’t a perfect picture, and there are sometimes events that hit us out of the blue and force us to respond.

By and large, however, the body of knowledge accumulated—and shared with Canadian Edge readers—is a pretty good guide for whether a position merits holding or folding. And in times like these when there’s are so many uncertain external factors, there’s nothing like a good business to fall back on.

Macquarie Power & Infrastructure Income Fund (MPT.UN, MCQPF) completed its takeover of Clean Power Income Fund last month. Clean holders who didn’t sell beforehand still face some uncertainty about their ultimate payoff. But it’s crystal clear Macquarie is geared up for strong cash flow growth as a budding player in the carbon-neutral power-generation industry.

As became evident during the progression of the buyout, Macquarie had stacked the terms in its favor, essentially forcing US owners of Clean to take the cash return it offered. Meanwhile, it was able to buy Clean’s assets—which finally began to perform to potential in the first quarter—on the cheap, ensuring the deal’s ultimate profitability.

That’s the kind of hardball tactic that tends to benefit shareholders, and I look for further, similar moves going forward. The trust’s second quarter payout ratio may be abnormally high, as dilution from the shares issued to buy Clean won’t be fully offset by revenue. That will reverse with a vengeance the rest of the year, as they’re combined with Macquarie’s other solid assets.

Macquarie shares are already bouncing back from recent lows they hit because of uncertainty surrounding the deal, a common condition for acquirers. Macquarie Power & Infrastructure Income Fund a buy up to USD12 for those who don’t already own them.

Like their US counterparts, Canadian real estate investment trust (REIT) shares were softened up by rising US interest rates last month. Unlike REITs to the south, however, the Canadians are still prime beneficiaries of a burgeoning property market. Royal Le Page Franchise (RSF.UN, RYPGF), a trust representing real estate agents across the country, reports conditions remain robust, particularly in the western part of the country.

The combination of weaker share prices and still-strong fundamentals has created another solid buying opportunity in the sector. That’s particularly true for our Portfolio REITs Northern Property REIT (NPR.UN, NPRUF) and RioCan REIT (REI.UN, RIOCF), and Canadian Apartment REIT (CAR.UN, CDPYF) in the residential sector.

With yields in the 5.5 to 6 percent range, these REITs may not look that attractive next to oil and gas producers. But on an apples-to-apples basis—i.e., with US REITs—there’s no doubt they’re compelling bargains. All three are set for solid growth in cash flow and distributions for years to come.

Dominion Bond Rating Service affirmed this positive thesis last month, placing RioCan REIT’s debt on review with positive implications. Canada’s leading credit rater noted the REIT’s steady improvement in its “risk profile” with consistent property upgrades and improvements to its client list. It also cited below-market rents at properties and a solid development pipeline, pointing the way to cash flow-boosting higher rents and occupancy rates down the line.

RioCan REIT is a buy up to USD25. Canadian Apartment REIT, a beneficiary of rising residential rents and occupany, is a buy up to USD19. Finally, Northern Property REIT—solidly situated in the fast-growing resource development regions—is a bargain whenever it trades under USD24.

A strongly growing economy always brings prosperity to the owners of major infrastructure. And there are few better representatives in Canada than AltaGas Income Trust (ALA.UN, ATGUF). The trust’s credit rating was affirmed by S&P last month with a stable outlook, an affirmation of the basic soundness of its ongoing asset expansion program. S&P cited the fee-generating nature of the trust’s assets, which include field gathering and processing, extraction and transmission, power generation and energy services.

AltaGas is also a featured stock in the advisory newsletter of our Canadian partner MPL Communications, another vote of confidence for this long-time Canadian Edge holding. Buy high-yielding, high growth AltaGas Income Trust up to USD26. Note that, like most trusts backed by strong businesses, it’s also a takeover target.

Bell Aliant Regional Communications Income Fund (BA.UN, BLIAF) looks to regain market share in its rural service territory following a series of favorable regulatory rulings lifting restrictions on its ability to compete. The trust also reached a deal with its principal union that should ensure amity as well as control costs.

With parent BCE now in a definite takeover agreement, Bell faces some uncertainty about what the new owners will do with their stake. As I pointed out last issue, the possibilities include a sale of the new owners’ shares, an attempt to take the trust private or simply the status quo. As the new owners are basically a consortium of private capital and a major Canadian pension fund, they’re not likely to view Bell strategically but rather from the standpoint of potential cash returns.

One thing that can be counted on is they won’t do anything to hurt the value of an asset they plan to sell. That should ensure against any disruptive selling. And the existence of independent directors and management means any privatization offer will have to be at a fair price. In any case, Bell is a very solid franchise on track for strong growth on its own, the key criterion for holding any trust. Bell Aliant Regional Communications Income Fund is a buy up to USD30 for those who don’t already own it.

Pembina Pipeline Fund (PIF.UN, PMBIF) remains the best-kept secret in the burgeoning oil sands region. The trust’s primary asset is its fee-based monopoly on pipeline transportation for the Syncrude Partnership, which remains the fastest-growing player in the sands. A recent redemption of a convertible security will limit future dilution, and it illustrates the cash flow power of this trust. Pembina Pipeline Fund’s shares have been volatile but always rate a buy when they trade under USD16.

The sector in the Canadian Edge universe with the least business risk is also the most interest-rate sensitive: power producers. These trusts basically operate facilities under long-term contracts with creditworthy parties, most of which factor in fuel-cost fluctuations. That, plus generally low debt levels, adds up to extremely reliable cash flows that allow the payment of very high distributions.

The flipside is lack of operating risk makes them more vulnerable to rate swings, as the graph “Rate Sensitive” illustrates. Basically, Algonquin Power Income Fund (APF.UN, AGQNF)—as well as our other power trusts, Atlantic Power Corp (ATP.UN, ATPWF) and Boralex Power Income Fund (BPT.UN, BLXJF)—trades in large part on the perceived value of its yield, which varies with changes in interest rates.

That was a negative in June because it was a positive other months. On the other hand, fundamentals of these trusts remain very strong. They’re also takeover targets for anyone who wants to accumulate carbon-neutral power assets, and they’re protected against post-2011 taxation.

For one thing, all have huge potential noncash, tax-reducing expenses. Algonquin also garners 67 percent of cash flow from US operations, which aren’t subject to the tax. Atlantic is 100 percent in the US, and its distribution is wholly exempt from the withholding tax by virtue of being part debt interest and part equity rather than a conventional trust distribution. Boralex Power is least protected, but it’s most likely to go to a high premium merger once its strategic review is wound down.

The bottom line is rate swings may affect these trusts in the near term. But long term, their fundamentals will carry them to strong returns. Algonquin Power Income Fund is a buy up to USD9, Atlantic Power Corp is a bargain up to USD12, and Boralex Power Income Fund is worth grabbing up to USD10.

Hump Season

The Canadian Edge Aggressive Portfolio is built around the most-volatile, highest-potential sector of the market: oil and gas producers and service trusts.

These trusts literally live and die based on energy prices. Their reliance on oil has been a positive this year, particularly with oil breaking above USD70 a barrel this month. Their reliance on natural gas, however, has been a decidedly mixed bag.

On the plus side, the surge in prices this spring—as a year of milder-than-normal seasons yielded to more normal conditions—gave trusts an opportunity to lock in higher prices on the forward curve. Because forward sales and hedging basically set the tone for cash flows, that likely means lower payout ratios and more-secure distributions for gas-reliant trusts later this year.

On the other hand, the market remains extremely sensitive to changing weather conditions, particularly in the gas-dependent Northeast US. Last month, the perception of weather conditions shifted to mild, and gas prices have plunged in response, even with oil prices heading higher.

The dip in gas prices has hurt share prices of producer trusts across the board, even the stronger ones, such as Enerplus Resources (ERF.UN, NYSE: ERF), that form the bulk of the Aggressive Portfolio holdings. The worst hit have been the gas-reliant trusts and the energy service trusts that get much of their business from them.

The graph “Hump Season” tells the story for our most gas-reliant producers: Paramount Energy Trust (PMT.UN, PMGYF) and Peyto Energy Trust (PEY.UN, PEYUF). Both have taken hits as gas prices have dipped.

There are, of course, stark differences between these two trusts. Peyto, for example, has very long-life reserves, a rock-bottom payout ratio, extremely low operating costs and little debt. That gives it enormous staying power when gas prices tumble. The payout, for example, was in no danger whatsoever last year, though gas prices fell by more than half from post-Hurricane Katrina highs.

In contrast, Paramount is among the most aggressive of trusts, 100 percent reliant on natural gas production and constantly challenged to replace its short-life reserves. The trust’s purchase of assets from Dominion Resources—which it closed last month—does extend reserve life considerably and should add some stability to cash flows.

But Paramount’s chief appeal and risk is that its fortunes are extremely leveraged to natural gas. If prices pick up from here, it holds the promise of a double or even a triple in short order. But if they should slump again, we’ll almost surely see another distribution cut.

The key isn’t to confuse short-term moves in the face of gas price volatility with real factors that determine long-term returns. Though it will move with gas prices, Peyto is built for sustainability. That makes it infinitely more suitable for conservative investors than Paramount, which is suitable solely for the very aggressive who want to bet on gas prices. With those caveats, Peyto Energy Trust is a buy up to USD22; Paramount Energy Trust is a buy up to USD13. Note my other aggressive gas play, Advantage Energy Income Fund (AVN.UN, NYSE: AAV), has fared well since last month’s recommendation. Advantage Energy Income Fund remains a buy up to USD14.

As for the energy service trusts, both Precision Drilling (PD.UN, NYSE: PDS) and Trinidad Energy Services Income Trust (TDG.UN, TDGNF) are extremely high potential situations and takeover targets. Neither, however, is likely to move much higher until one of two things happen: Either natural gas prices have to move enough to revive Canadian production, or these trusts have to expand sufficiently in the still-robust US market to offset Canadian weakness.

One or the other, if not both of these factors, are inevitable. But until they move, it’s going to take patience to own these trusts. The good news is their distributions appear to be secure and finances solid, even with industry conditions at low ebb. But they’re for aggressive investors only. Buy Precision Drilling up to USD30 and Trinidad Energy Services Income Trust up to USD18.