Income trusts, which have surged in popularity in Canada, are being offered on the New York Stock Exchange as antidotes to shrinking stock portfolios and tiny fixed-income returns.
The income trusts generally provide rich income streams, as high-yield bonds do, but the trusts are actually equity investments. Their value can shift sharply, and the payouts are by no means assured.
PHOTO: NY TIMES
Despite the risk, many investors in Canada have been drawn to income trusts because of the prospect of consistently high yields.
"Because a large number of baby-boom investors are nearing retirement, they're looking for stability of income," said Stephen Pincus, a partner at Goodmans, a law firm here that has helped structure many trusts. "They can't afford to invest in stocks, which require a long period of time to harvest capital gains."
Like real estate investment trusts, the Canadian income trusts raise capital through an offering of units, or shares. They invest that capital in the equity and debt of an operating company and distribute most of their pretax operating income to investors. Shareholders can count on the income only if the underlying business continues to generate stable cash flow.
In early March, the Fording Canadian Coal Trust, which controls North America's biggest exporter of coal for making steel, listed its units for sale on the New York Stock Exchange. The trust replaced Fording common stock as part of a merger with two other Canadian coal producers. Fording's shares closed at US$19.08 on Friday, roughly the level at which they were listed. Three other Canadian trusts -- the Enerplus Resources Fund, the Pengrowth Energy Trust and the PrimeWest Energy Trust -- have also listed in New York.
More than 100 trusts have been set up in Canada the last two years. They accounted for 57 percent of the value of new listings on the Toronto Stock Exchange last year, said Kirby Gavelin, head of equity capital at RBC Capital Markets here. Currently, he said, the trusts account for about 7 percent of the market value of the S&P/TSX composite index, the main benchmark for stocks on the Toronto exchange.
Canadian income trusts were initially confined largely to the oil, gas and real estate sectors. But those set up recently are in industries as diverse as horticulture, food processing, check printing and telecommunications. The most suitable candidates have been well-established businesses with stable cash flow that is not required for new capital investment.
"Beware of businesses with significant reinvestment needs," warned Gordon Tait, who watches income trusts at BMO Nesbitt Burns in Calgary, Alberta.
Solid yield
The typical yield on an income trust is 8 percent to 14 percent. Most have also produced significant capital growth. An income trust index compiled by BMO Nesbitt Burns gained 6.4 percent in the 12 months ended March 31, compared with a 17.1 percent decline in the S&P/TSX composite.
Many Canadians protect the distributions from taxes by holding the trusts in registered retirement savings plans.The Canadian trusts have received relatively little attention from Americans, in part because of the small size of most of the offerings, typically around 250 million Canadian dollars each, and because of the uncertainties of investing in foreign securities.US residents are subject to a 15 percent Canadian withholding tax, though this can be applied as a credit against American taxes. Under Canadian law, no more than half the units of any trust may be held by foreigners.
Currency risk is also an issue, because almost all the trusts, including those listed in New York, pay their distributions in Canadian dollars. The currency has strengthened in recent months; it now trades at US$0.6885.
Michael E. Lewitt, president of Harch Capital Management in Boca Raton, Floriday, said that although he is familiar with the securities, his company has not invested in them or recommended them.
"It's something we haven't really thought about," he said.
But Pincus of Goodmans said, "As time goes on, I think we'll see a greater number of American investors participate in this vehicle."
American companies generally have not formed income trusts in the United States because they would be regulated as mutual funds, with strict reporting requirements and limits on fees, according to Andrew F. Viles, a partner at the law firm of Goodwin Procter in Boston. From an investor's point of view, he said, "one of the great things is that it's like a fixed-income product, so long as the business continues to perk along as it has."
The trusts' risks stem from their status as equity holdings. The absence of any cash-reserve buffer makes them especially vulnerable to changing business conditions, but some investors may not be aware of that.
"You've got widows and orphans buying units and expecting dividends on a regular basis," said Kenneth Pearce, a partner at the law firm of Blake, Cassels & Graydon here.
The risks were evident late last month when the Halterm Income Fund, whose main asset is a container port in Halifax, Nova Scotia, suspended income distributions after two shipping lines moved their business elsewhere. And the Sun Gro Horticulture Income Fund of Bellevue, Washington, whose underlying business is North America's biggest peat moss distributor, warned last month that its earnings for the 12 months ended March 31 would not be enough to cover distributions.
The prices of both trusts' units, which are listed on the Toronto exchange, have slumped sharply.
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