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Mathew Ingram

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The dust has settled

Mathew Ingram


Finance Minister Jim Flaherty certainly knows how to get the market's attention in a hurry. His surprise announcement (on Halloween, no less) that trusts would be treated the same as normal corporations for tax purposes was a bombshell that pushed the trust index down by more than 13 per cent, as investors tried to sort out what would be left of the market once the smoke cleared. Even as many were dumping trust units as fast as they could, however -- and criticizing the federal government for blind-siding them -- some investors were busy snapping up units at a discount.

Why? Well, for one thing, because not every income trust is going to be laid low by the Flaherty decision. Quality income trusts are still likely to be good investments. Their distributions will simply be treated like dividends for tax purposes, and investors in many cases will be able to use the dividend tax credit to shelter some of that income. They might not be as high-yielding as they were when they were income trusts -- the average payout on trusts before the taxation change was more than three times the average dividend yield on the stocks in the TSX Index -- but they are still likely to be good investments.

In other words, one potential response to the change is to do nothing; or rather, to continue to buy or hold quality trusts -- that is, trusts with long-life assets that are likely to produce a relatively stable amount of cash over the long term, and those with a history of either maintaining or increasing their payout ratios. In other words, avoid trusts like Gienow Windows & Doors Income Fund, whose yield is high (above the 15-per-cent mark) primarily because its stock has fallen. And why has the stock fallen? Because the trust has reduced its yield twice in the last year, and that makes investors nervous.

Another reason to think about staying put in trusts is that the new tax rules don't take effect until 2011. That means investors still have more than four years to take advantage of the high yields that some trusts are currently enjoying. In other words, you could get the benefit of those yields for several years while scouting out other high-yielding investments, rather than rushing to sell your trusts at the bottom. Obviously, it's unwise to wait until the last possible minute, but it doesn't make sense to be too early either, especially when some trusts continue to be good investments with high yields.

"This, too, shall pass and when the dust settles, you will say [trusts] are still an attractive asset class, you're now getting a higher yield because of the 15-to 20-per-cent downward marking [and] you have a four-year tax holiday," said Gavin Graham, director of investments at Guardian Group of Funds.

It's also worth noting that the restrictions on income trusts don't affect one major segment of the trust sector, and that is real-estate investment trusts or REITs. The federal government decided that real-estate trusts (as in the United States and several other countries including Australia) could continue to use the so-called "flow through" business model and thus avoid extra taxation. That means investors are free to continue investing in REITs just as they did before, although many real-estate trusts saw their unit prices fall along with the rest of the trust market following the Flaherty announcement.

"Demand for REITs has been strong, and this should probably pick up because of the legislation," Michael Smith, an analyst with National Bank Financial, told the Toronto Star. Fred Waks, chief operating officer of RioCan REIT -- the largest real estate trust in Canada -- said he expects to get some more interest from investors looking for something to replace their other trust investments. "I think, when the dust settles, there will be a flight to capital for people who are looking at income investments," he said. "It looks like a very positive thing for the industry."

Lee Goldman of Split REIT Opportunity Trust, which invests in REITs, said that Canadian real estate trusts will likely "benefit from a reallocation of capital to them by investors exiting other income trust categories." And Frank Mayer, vice-chairman and real estate analyst with Desjardins Securities, said that after an initial period of uncertainty among investors, "we see REITs coming off smelling like a rose."

So what else could you do besides sticking with your existing trusts for four years or switching to real-estate trusts? One other option became obvious as soon as the Flaherty decision was announced, when the TSX index dropped precipitously, only to rebound as investors moved out of income trust units and into bank stocks. Before income trusts became so popular, the dividend-paying stocks of choice for conservative investors were bank stocks, and some market watchers say it's likely that many advisors will encourage their clients to move back into the bank stocks at this point.

Another option: U.S.-based income trusts. If your portfolio can handle some more foreign investment, it might be worth looking at some of the larger American income trusts, although you should obviously do the usual amount of due diligence first. A columnist with Kiplinger's Finance newsletter recently recommended what he called "such American standbys" as San Juan Basin, Cross Timbers and Sabine Royalty Trust.

Although their yields are not as high as some of the Canadian trusts that are being phased out, at an average of about 8 per cent they are still substantially higher than many dividend-paying stocks.

The bottom line is that the Flaherty announcement is not the end of the world. There are still worthwhile trust investments to be found, provided you take the time to look for them, as well as alternatives that can take the place of those trusts you do decide to sell.

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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