Implications for Income Trust Investors

There are many things in life that look really easy, until you try to do them yourself. Often, what makes them difficult is that our instinctive reaction gets in the way and success only comes after we unlearn what our bodies or minds do naturally. Novice golfers often find that the ball travels straighter when they use less muscle and learn to keep their head down and their eyes on the ball. New drivers often tend to look at the terrain 5 feet in front of the car when they should be looking forward a hundred meters, putting them at risk of rear-ending the person braking in front of them. In most cases, there is a discipline that must be learned, often with some coaching.

Income investing may very well be another example. At first blush, most of us would view it as a simple
task of maximizing the income earned, or meeting some predetermined income threshhold. However, for
those seeking to maximize current income while maintaining or growing the purchasing power of their
assets, investing represents a very challenging balancing act. The key difference is that in our examples
above, feedback usually comes pretty swiftly- either in the form of a lost ball or a bent fender. For
investors, it may be possible to get it wrong but still look good in the near term; the real proof of success
is often measured over many years. Given that what is at stake is our financial well being, this is not a
skill one would want to learn by trial and error. There are no Mulligans.

A significant challenge

For anyone who is concerned about the long term ability of their assets to generate income, inflation
represents a moving minimum return target that investors must achieve before they can even start to think
about their spending needs. Reinvestment of at least a portion of income is an important factor in the
growth of a portfolio.

Bonds, in particular, have left a lot to be desired in this low interest rate environment. Not only is interest
income least efficient from a taxation perspective, but after taxes, inflation eats up a significant proportion
of what’s left. If you spend all of this income, you are highly likely to erode the purchasing power of
your portfolio over time.

For many, the solution to this challenge lies in adding an exposure to common equity. Though definitely
more volatile in the short term, equities have outperformed bonds over the last 50 years, and they have outperformed bonds for a significant number of 10-year periods over this time.

Moreover, as the two assets do not always move in the same direction, there are also benefits of
diversification which means that investors can expect to achieve higher returns for any level of volatility
than if they invested in only stocks or only bonds. Finally, while rising inflation and interest rates will
reduce the value of most income-oriented assets, equites offer exposure to companies who have
demonstrated an ability to grow revenues and profits in these kinds of environments.

A yearning for “something else”

Unfortunately, given that dividend yields are usually lower than bond yields, one of the downsides to this
approach is that the actual income received in a portfolio usually fell, leaving the investor looking for
capital gains to fund their income needs. And given that equity markets have lost ground in three of the
last four years, it is not surprising that investors have been looking for something else.

That ‘something else’ came in many forms over the last number of years, including perpetual preferred
shares and various commodities and derivatives-based structured products. However, it has been the
emergence of the income trust market that has had the most profound impact on individual investors.

Growing from under $10 billion in assets in 1996 to almost $90 billion today, with roughly half of the
growth in the last 2 years, income trusts have struck a chord with investors because they provide a regular
income stream that is unmatched by any other security available. In addition, this market has had the
wind at its back in the form of persistently falling interest rates (until recently), a reasonably strong
economy, and an unprecedented rate of funds flowing into this market. Excess demand for the relatively
high income caused values to rise, providing holders with large capital gains and attracting attention from
more and more investors. In aggregate, this market returned approximately 32% (total return) in 2003
and averaged over 22% per year for the five-year period ended in 2003.

Rising interest rates pose a threat ….

Of course, the recent rise in bond yields has done much to stir debate on the future of this asset class as
prices dropped between 10-15%. If we valued income trusts just on the basis of their current
distributions, a 1% rise in interest rates should equate to a drop in unit value of approximately 9-11%.

However, the impact of rising interest rates could actually be much greater. As interest rates fall, demand
for income increases, creating a virtuous cycle where yields on income trusts fall by more than yields on
bonds. A reversal in the trend in interest rates could trigger a reversal of this cycle, causing income trust
yields to rise by a greater amount than bond yields.

And this could be exacerbated by liquidity limitations. More specifically, demand for trusts comes almost
completely from distribution-oriented individual investors. The risk when any one class of security is
pursued aggressively by a specific and limited group of investors is that when they decide to sell, there
are few others there to step in and support the market. Price movements can become exaggerated as the
pendulum swings from one extreme to another before settling in the middle.

Predicting interest rate movements is tricky at the best of times and even though rates have started rising,
it is difficult to determine with conviction if they will go far enough and fast enough to cause a worst-case
scenario in the income trust market. RBC Asset Management Chief Strategist Dan Chornous, in his most
recent Strategy update, targeted a 5.50% yield on 10-year Canada bonds over the next 12 months, versus
approximately 4.45% at present. This kind of increase is definitely material, but once the dust settles and
prices are adjusted, it is not likely to alter the fact that there will be few, if any, alternatives offering
distributions that can match those of income trusts on an absolute basis.

…. but interest rates are not the only risk!

At the very least, rising yields potentially signify the end of the bull market in income trusts and should
give one pause to consider how much income trusts we should own. However, in our view, the concerns
of income trust investors do not end with rising interest rates.

Income trusts are simply another form of equity, one that pays out the majority of their cash flows instead
of reinvesting them to grow the business. Both rank legally at the bottom of the capital structure after all
other creditors, and their prices and distributions are impacted directly by the bottom-line profitability of
the company. As such, neither the price nor the distributions from income trusts are guaranteed
and it is possible to lose money.

Unfortunately, if history is any guide, whenever a market experiences the kind of success trusts have
enjoyed for so long, investors tend to become somewhat complacent about risks. As a result, some
investors may have come to rely on income trusts to satisfy an increasingly large amount of their income
needs, to the point where they may have devoted more funds than they would otherwise be consciously
willing to devote to equities.

No margin for error

Both traditional corporations and income trusts could be forced to reduce their distributions if their
profitability falls. However, a conventional corporation that typically withholds a large portion of its
earnings for reinvestment will have much more flexibility in maintaining its dividend than an income
trust, which typically pays out substantially all of its income and therefore will have a much smaller
buffer. And considering that income trusts are mostly sought for their distributions, a more widespread
reduction in payouts could have significant negative consequences for the income trust market.

History gives us ample evidence of what happens when distributions fall. Exhibit A is the story of
TransCanada Pipelines (now TransCanada Corp.) which was widely viewed as the quintessential ‘widow
and orphan’ dividend stock until it cut its dividend.

Exhibit B, covers the royalty trust market back in 1997. A perfect storm of
rising interest rates and falling oil prices caused market values to drop precipitously. While rising interest
rates were definitely a factor, falling oil prices and their impact on distributions were the dominant factor
in the dramatic price declines that took place.
In both cases, values fell by more than 50% from their peaks. (With the benefit of hindsight, the
pendulum swung far enough to provide extraordinary returns for any investors who ventured into the
storm.)
Even without specific cuts in distributions, a broad economic downturn should also have far ranging
implications for this market. As corporate profits fall, so do corporate bond prices. Being more leveraged to profitability than bonds, income trust yields should exhibit a similar pattern, but to a much
greater magnitude.

A matter of proportion.

What this means is that investors should examine the quality of their holdings and carefully consider what
size allocation is appropriate for their portfolio. Our suggestion, when the investor’s objectives are to
generate income, is that income trusts should be no more than 40% of the equity allocation of a portfolio.

In other words:

• If you are a conservative investor with 70% bonds and 30% stocks, income trusts should
  comprise 12% of your total portfolio.
• For a more growth oriented income portfolio with a 50/50 bond/stock split, the maximum
  corresponding trust allocation would be 20%.

In addition, we would strongly suggest that diversification within the trust holdings also be carefully
considered. Ideally, an investor would hold as wide as possible a range of trusts in varying industries in
order to diversify their risk, with no one issuer representing more than five percent of an equity portfolio.

But how can I replace the lost income?

For investors who find themselves in a position where changes are warranted in their portfolio, the logical
next question is “What are the alternatives that will give me the same level of income?” However, in our
opinion, the real question is whether or not the distributions derived from trusts should be seen as
income in the first place.

We know that reinvestment of income is important for preserving the purchasing power of our assets, but
it is also important to reinvest the income from riskier securities against potential future losses.

For perspective, we can look at the High Yield bond market. Given the significant risk of default and a
higher price sensitivity to company profitability versus interest rates, High Yield bonds can be viewed as
equity alternatives that pay a significant proportion of their returns in the form of income distributions ….
sound familiar?

The underlying principle of High Yield bond investing is that over any reasonable investment horizon,
you will lose money through defaults. If highly diversified (i.e. no position represents more than 2% of
the portfolio), the incremental yield will be enough to offset the losses and still provide higher returns
than government bonds. What this means is that this income does not exist solely to be spent; a portion
should be reinvested to make up for potential future losses.

Building a sound income portfolio

Income trusts are by no means poor investments when used properly in a portfolio context. That many
income-starved investors seem to have turned to them for larger and larger proportions of their portfolios
provides us with a useful example to raise our main point, which is that managing risk in order to achieve
a balance between current and future income is a very difficult pr oposition. There is the tradeoff between
the relative safety of bonds and the potential higher returns and volatility of equities. There is the fine art
of determining how much of the distributions received should be spent versus reinvested. There is an
increasingly broad range of sophisticated investment solutions to choose from. And we have not even
begun to touch on the impact of taxation.

However, there is one other aspect that hampers the success of even the most seasoned investors.

With the benefit of 20/20 hindsight, it may be easy to wonder why so many people threw so much of their
hard earned money at companies that lacked any demonstrable profits or viable business plans in the run
up to the big tech bust in 2000. It is also easy to lament the lost opportunities in bonds. At any time up to
the mid 1990’s, it would have been possible to buy long-term government debt with yields of 8% or
higher, that would still be paying these rates for another 15-20 years. However, memories of higher rates
made it difficult for many to accept that bond yields were in new territory, and the broad consensus
amongst investors was to stay relatively short as rates would surely rise.

There are many other examples, but the point is that as individuals, we find it difficult to ignore when our
friends and peers are making a lot of money, and we find it equally difficult to venture out and do what
nobody else is willing to do. Often, this can lead us to take inappropriate risks, or miss useful
opportunities. Overcoming our own emotions can be the key to effective investment management, and it
requires following a discipline that recognizes the following points:

• Reinvest. Distributions do not equal income. The amount of income that can safely be taken out
  of even the more aggressive portfolios without jeopardizing future earnings power is not likely to
  be much higher than the yield on high quality bonds.

• There is no magic solution. Anything that offers higher returns than a government bond implies
  higher risk. Avoid any investment where you cannot readily identify both the source of this risk and the worst-case outcome if everything were to go wrong.

• Diversify. Adding risk to a portfolio will help increase the odds of long term success, but only if
  it is done responsibly, meaning:

1. Holdings of any one type of security are limited according to a pre-determined strategic asset allocation and,

2. Holdings within each asset class are diversified, with no one issuer exceeding 5% (at most) of the portfolio (other than governments).

3. Most portfolios should hold at least some government bonds.

4. Bond holdings should be laddered amongst a number of maturities (probably out to at least 7-10 years).

• Avoid making investment decisions solely according to yield. Yield is only one of the factors
  that frames an investment decision. Not only does a higher yield indicate a potentially higher risk
  of loss, but focusing primarily on yield-oriented solutions will also increase interest rate
  sensitivity of your portfolio. Consider putting some money into investments that may perform
  better in a rising interest rate environment, even if the yield is lower.

• Consider after-tax performance. Many investments offer some form of tax advantage.
  However, investor tax rates can vary substantially between provinces and investor types
  (individual vs. corporations). If the price is set by investors with different tax circumstances than
  yours, the after-tax yield may not be sufficient to compensate you for the risks to are taking.

• Avoid following the crowd. There is nobody out there who knows something that you don’t.
  They are just taking more risk.

• Do not take unnecessary risk. Income needs that greatly exceed what is achievable in the market
  may require investors to consider options that liquidate their capital in an orderly fashion, rather
  than taking the risk of losing it prematurely.