Retirees who are living off their investments face a very significant problem today. With markets taking a beating and fixed income investments still at significant lows, investors are turning to income trusts to help them create income in these turbulent times.
In fact, investors are pouring money into income trust type funds that the category has grown on average 247% over the last 12 months.
What are income trusts?
According to Leslie Lundquist, manager of the Bissett Income Fund “Income trusts are equities, not fixed income. Most trusts generate cash by producing a product or service, selling it, and using the proceeds to pay for all expenses. What's left after expenses go to unitholders. The trick to being a trust is that there has to be a lot of cash left over after expenses in order to generate distributions to unitholders. Trusts are a good investment for people who have already accumulated their retirement assets, and who now wish to live off of them.”
Essentially, the focus of the income trust is to generate attractive cash flows for its owners. This contrasts with most other business entities, where making cash distributions is less important than the reinvestment of the firm's net cash flow in the expansion of the business.
Why are income trusts so popular?
One of the reasons is for income yields. I took a look at three ‘true’ income trust mutual funds in Canada. My criteria was they had to have at least a three year track record and there had to be at least 80% of the fund invested in income trusts. With GICs producing yields of 2.5% to 4.5%, income trust funds are very attractive yield producing investments with current yields of 7.6% to almost 9%. If you take the after tax benefits of income trusts the income is almost double that of a traditional GIC investment.
|Renaissance Cdn Income Trust||8.42||0.063||8.98%|
|GGOF Monthly High Income||8.92||0.060||8.07%|
|5 Year GIC||4.50%|
The other reason is that the performance of this asset class has been stellar in this bear market. In fact, I think that investors who do not need income are flocking to this asset class even though they have no need for income. Chasing performance continues. The average 1-year return in this mutual fund category is 13.7%. Over the last 3 years, this category has compounded a 12.2% return. Compare this to the average equity fund and you would be happy with positive returns, let alone double-digit returns.
|1 year||2 year||3 year||4 year||5 year|
|Renaissance Cdn Income Trust||19.10%||23.60%||17.70%||11.50%|
|GGOF Monthly High Income||19.90%||22.20%||16.20%||12.00%||8.20%|
|Average Income Trust Fund||13.70%||16.00%||12.20%||8.30%||6.90%|
Making the right decision
According to John Priestman, manager of the GGOF Monthly High Income Fund, you should buy an income trust fund for stable, tax efficient income. These investments provide attractive yields but also come along with a risk premium.
If you are looking to buy income trusts, you must understand the risk of the asset class. Many people are not aware that income trusts went through a bear market in 1998/1999 that lasted for a year and half to two years. In this bear market, some income trust funds lost as much as 30% in a 12-month period. And over the last 5 years, they have lost money about 30% of the time.
Priestman warns “This asset class is growing rapidly and you must be very careful about the individual trusts you buy. One of the best ways to buy income trust is to buy a diversified portfolio through mutual funds.”
My two cents
I am always concerned when investors flock to a class of investments after good performance. That being said, I think income trusts are great investments for retirees looking for income yields. Make sure you understand that there is risk associated with this asset class and that income trusts have had a very solid run for the last few years. It is inevitable that your capital will fluctuate both up and down and that your income yield is not guaranteed. Finally, make sure income trusts are a part of your portfolio and not your entire portfolio. Far too often I see this asset class being bought in large doses. Remember diversification is one of the eternal principles to investing.