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Mathew Ingram

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A matter of trust

Mathew Ingram


TORONTO (GlobeinvestorGOLD) - So, Finance Minister Ralph Goodale didn't change the tax rules on income trusts as many feared he might. Instead, he altered the way dividends are treated, in order to even the balance between trusts and stocks. Having dodged a bullet, trusts quickly bounced back from the shellacking they had been taking on the Toronto Stock Exchange. But just because Ralph didn't go forward with the market's doomsday scenario doesn't mean all is well in trust-land. Smart investors would be wise to use the dawning of a new year as an opportunity to question their reliance on income trusts, and to weed out those that are less deserving.

Among other things, the easing of dividend-taxation rules is likely to make trusts less attractive than they have been when compared with regular stocks (at least those with dividends). One of the driving forces behind the trust explosion over the past five years was the difference in how tax rules were applied to stock dividends and to distributions from trust units (which are not considered dividends). Simply put, the differences made it more appealing for companies to issue trust units, and easier for them to offer high payout rates on those units. Some of that advantage will be lost with the changes to tax rules.

At the same time, a flood of new trusts is expected to come rolling down the pipe in the new year. Sources say that Bay Street brokerage firms are working on about two dozen new income trust offerings, which could raise a potential $5.5-billion in financing. Some of those are likely to be IPOs that were shelved during the uncertainty surrounding Mr. Goodale's plans for the sector, but most of them will be new issues. The volume of new trust offerings is expected to eclipse last year's performance, when trusts accounted for almost 75 per cent of the new share issues that were floated on the Toronto Stock Exchange.

That rush of new offerings is likely to dilute the market demand for existing units, which could put pressure on any trusts that were planning to raise money by issuing new shares. And some of those who will feel the pressure are trusts whose distributions are already in doubt - companies that have seen their underlying businesses fall short of generating the necessary cash to support their payout rates. Some will almost certainly cut or suspend their payouts.

Here's a good New Year's resolution: Pore over your trusts, whether they are held outright or through a mutual fund you own. Check their distribution track record and their yield (the annual payout divided by the unit price), and pay particular attention to those trusts whose yields are the highest. You might think that these are your stars, but high yields are not necessarily something to brag about. In many cases, a high yield - in the low to mid-teens or higher - can be a sign that a company is paying out too much of its cash earnings, which in turn raises the possibility that the trust will have to chop its payout rate.

Looking just at a trust's yield is "a formula for disaster" particularly when investing in smaller trusts, analyst Brian Pow of Acumen Capital in Calgary said recently. In many cases, high yields are a sign that the market is pricing in a higher risk than comparable trusts. Take Vancouver-based Swiss Water Decaffeinated Coffee Income Fund, for example: its yield might have looked appealing when the trust was paying out 11 cents a month, but on December 8 the company said it was cutting its distribution to 7 cents a month due to the loss of a customer. The trust's unit price fell by more than 40 per cent on the news.

Even a fairly large trust can suffer from a significant event that forces it to cut its payout rate. The Legacy Hotel REIT, which operates some of the most prestigious hotels and resorts in Canada, had to suspend its distributions after the SARS outbreak slashed tourist traffic to many of its properties in 2003. And Clearwater Seafoods Income Fund, which operates the largest freshwater seafood business in North America, had to cut its payout in October, which pushed the trust's unit price down by more than 35 per cent. The company blamed the high value of the dollar and a sudden increase in costs for its fleet of ships.

Can you tell whether a trust such as Legacy is going to get hit by an unusual event? No. But you might have been able to tell whether Clearwater's distribution was in danger of being cut, since the company had been paying out more than 100 per cent of its free cash flow for several months before making the announcement. Swiss Water Decaffeinated Coffee also had a yield of 11 per cent, which should have raised more than a few warning flags.

So take a look at some of your high-yielding trusts, and in particular take a look at how much of their cash flow they have been paying out every month or every quarter - and ask yourself what the odds are that they'll be able to keep doing so. Think of it as a belated Christmas gift to yourself.

Mathew Ingram joined The Globe and Mail's online news team in June of 2000, after spending four years as the Western business columnist, based in Calgary.

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