8 opportunities in a post-income trust era

The short-lived era of income trusts came to an end on Jan. 1 — sort of. That was the date that the federal government’s new tax on trusts, limited partnerships, and similar high-yield securities came into effect. In the run-up to tax-day, dozens of trusts converted to corporations, leaving only a handful of stragglers in what had once been Canada’s fastest-growing investment sector with some $200 billion in assets at its peak.

The fate of the trusts was sealed on Halloween 2006 when Finance Minister Jim Flaherty announced the Conservative government was breaking a specific election promise and imposing a tax on “specified investment flow-through securities” or SIFTs.

He called it a “Tax Fairness Plan” but many Canadians, especially those who had come to rely on income trusts for cash flow during a period of low interest rates, saw nothing fair about it at all. Shares of income trusts plunged in value, putting a big dent in the savings of thousands of retirees. Despite the criticism that followed the announcement, Mr. Flaherty stuck to his guns and the tax is now law.

So what should income-seekers do now? With interest rates still low, old stand-bys like guaranteed investment certificates (GICs) are offering returns that barely keep up with inflation. Money market funds earned only 0.18 per cent on average in 2010. Ten-year Canada bonds yield only 3.3 per cent.

But there are other options and many of them carry less risk than some of the marginal securities that were being peddled during the heyday of the trusts. Here are some examples. Remember that distributions/dividends are not guaranteed and could be changed at any time. Also, I want to stress that I am not recommending that you buy the securities mentioned below; they are only cited as illustrations. Talk to a financial advisor before making any decisions.

Income trusts. Yes, there are a few of them still around. After careful analysis, some management teams decided it would be too costly to convert to a corporation and that the tax advantages of doing so would be minimal. Brookfield Renewable Power Fund (TSX: BRC.UN) is one example. It is one of the largest power income funds in North America and its generating stations produce electricity exclusively from clean, renewable sources: hydro and wind power. The fund pays monthly distributions of $0.10833 per unit ($1.30 per year) for a yield of slightly over 6 per cent. Since the SIFT tax came in, the distributions are eligible for the dividend tax credit if the units are held in a non-registered account.

Limited partnerships. There are also a few publicly-traded limited partnerships still available. These are structured differently from income trusts but from an investor’s perspective they operate in much the same way. They too are subject to the SIFT tax but despite this at least one LP recently increased its pay-out. That’s Inter Pipeline Fund (TSX: IPL.UN), a Calgary-based partnership that owns and operates pipelines, storage facilities, and other energy infrastructure assets in Western Canada and Europe. In November, the board of directors approved an increase of 6.7 per cent in the monthly distribution from 7.5 cents to 8 cents per unit (96 cents a year). At that rate, the annual cash yield is about 6.3 per cent.

High-yield stocks. One of the legacies of the trusts was a new class of high-yield common stocks. These are the corporate entities that emerged after trusts converted in advance of the new tax. In some cases, they have maintained their distributions at the previous levels, making them very attractive to income investors, especially since the dividend tax credit now applies. There are dozens of these, many of which are in the energy sector. Crescent Point Energy (TSX: CPG) is one example. It is a conventional oil and gas producer with operations in Saskatchewan and Alberta. It converted to a corporation in mid-2009 but maintained its distribution at the same level of 23 cents a month ($2.76 a year). At the time of writing, the projected cash yield for 2011 was 6.3 per cent.

REITs. Most real estate investment trusts are exempt from the SIFT tax. As a result, their prices have moved up significantly in recent months although most still offer yields between 5 per cent and 6 per cent. These payments are not eligible for the dividend tax credit, but they do offer some other tax advantages.

Stapled notes. A few years ago, Bay Street introduced a new type of hybrid security. A share of common stock was coupled with a portion of a debt security to create what are known as “stapled notes.” The distributions are a combination of dividends and interest. They never really caught on but there are a few still around and they are not subject to the new tax because the underlying structure is a corporation. One example is Medical Facilities Income Fund (TSX: DR.UN). Although the shares trade in Canada, all the assets are in the U.S. in the form of specialty hospitals in South Dakota, Oklahoma, and California. The units pay a monthly distribution of 9.17 cents a month ($1.10 a year) to yield 9.3 per cent at the recent price. Note that only the dividend portion of the payment (about one-third) is eligible for the dividend tax credit.

Traditional blue-chip stocks. Most banks, utilities, and telecommunications companies pay reasonable dividends, although the cash return won’t be as impressive as those available from the new high-yield stocks. For example, BCE Inc. (TSX: BCE) currently yields 5.4 per cent, Fortis Inc. (TSX: FTS) pays 3.3 per cent, and Royal Bank (TSX: RY) has a yield of 3.7 per cent. However, these stocks offer capital gains potential and some have a long history of annual dividend increases — Fortis has raised its payout for 38 consecutive years.

Preferred shares. These shares offer a specified rate of return which may be either “fixed” or “floating” — the latter type is tied to movements in interest rates. The yields are normally higher than for the common stock of the same company but there is little capital gains potential. Also, fixed-rate preferreds are vulnerable to a price drop if interest rates go up.

Income-oriented mutual funds and ETFs. There are many funds that offer monthly cash payments but check their track record to be sure they aren’t giving you back your own money. The key is the history of the net asset value (NAV). If it is steadily falling, it means that the fund is not generating enough profit to maintain its payments and is, in effect, paying you back your own capital.

As you can see, there are plenty of income securities remaining despite the demise of most of the trusts. But remember: the higher the yield, the greater the risk the market is attributing to a security.

Gordon Pape is editor and publisher of The Income Investor newsletter. His website is www.BuildingWealth.ca