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Mathew Ingram

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Understanding income trusts

Mathew Ingram

  

When investing, sometimes it's handy to review what we've learned, so let's try a simple quiz: An income trust is a) just like a common stock, except you get "units" instead of shares; b) a better investment than a stock because you get paid distributions regularly; c) as safe as a bond, because you get what amounts to a regular dividend; d) a good way to get exposure to new and emerging sectors like Internet entertainment; e) all of the above.

If you chose any one of the above answers, you are — how shall I put this? — wrong. Let's be clear about one thing: I'm not suggesting that there's anything wrong with income trusts per se. They are a great investment for many people in many situations, and there are plenty of companies that use the trust structure to its best advantage. However, they are not for everyone, nor do all companies (or investors) benefit from becoming a trust, and there are also a lot of misconceptions about them as an investment.

Let's take the first point from the quiz above: trusts are not like common stocks, and not just because they call what investors receive a "unit" instead of a share. Common stocks include certain rights, including the right (in most cases) to a vote at shareholder meetings, the right to appoint representatives to the board, and so on. They also include rights that entitle holders to receive some kind of payment — after other investors such as bondholders — if the company becomes insolvent, and the right to take action against the board if they believe they are being oppressed.

In many cases, income trusts don't have to give unitholders the same rights, because they are not governed by the same rules as common-stock companies. Many trusts have a multi-level corporate structure that makes the actual operating company a subsidiary of the trust, which in turn is controlled by a management company, which in many cases is privately owned. The trust is often structured so that the management firm has rights which supersede those of the unitholders, and many of the terms of the management contracts and so forth can't be voted on or changed.

As for the second and third points from the quiz, many people believe that because trusts pay out dividend-like monthly distributions, and are often described as having a "yield" just like a bond, that they are either as good an investment as a dividend-paying stock, or as safe as a bond. In fact, they are neither, although they can be both safe and dependable. However, those distributions are in many cases not just a payment of excess cash flow from the company but in part a repayment of the principal invested — which is why they aren't referred to as dividends.

In part, it is this difference that allows income trusts to be taxed differently by the government, which forms part of their appeal, and also helps to explain why some companies are so eager to convert their operations into income trusts. In some cases, however — including some recent ones — the companies in question stretched themselves and their businesses too far to pay out those distributions, and have found themselves cutting or even suspending them for substantial periods of time. That's another reason not to think of them as being the same as a dividend on a common stock.

The last point in the quiz is also worth thinking about. For the most part, income trusts are good vehicles for investments that have a long lifespan and a relatively steady flow of income or cash — not necessarily growing, but steady or dependable. Alberta's oil sands make a great income trust vehicle, and so does coal, and so do some forms of real estate. Although all three sectors have suffered from short-term problems driven in part by fluctuating commodity prices, the long life of their assets makes them a fairly good candidate for the income trust structure.

In general terms, the shorter the lifespan of the asset and the more volatile the pricing of that asset or service, the less that company fits the income trust structure. If you are planning on investing in one, think about that — and also about what rights you are giving up, what terms the management arrangement includes, and what the risks are to the cash flows that form the distributions you will be counting on as an investor.

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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