An Inside Look at Income Funds

A few weeks ago I spent some time talking about income funds. This lead to a number of questions from readers searching for more information about the composition of these funds: Income trusts and Real Estate Investment Trusts (REITs).

I went to three experts to discuss Income Trusts and REITs:

  • Leslie Lundquist, manager of the Bissett Income Fund
  • Alan Wicks, manager of the Elliott & Page Monthly Income Fund
  • John Priestman, manager of the Guardian Monthly High Income Fund

What are income funds trying to achieve?

The consensus is that high, stable, tax efficient income is the first priority of any income fund. Managers know that people who buy these funds are looking for regular cashflow.

The second priority is generally to preserve the capital while maintaining the income. Finally, the third priority is capital appreciation. One general rule of thumb to live by is funds with a higher yield are less likely to grow capital. If you are hoping for capital appreciation, you might want to look for a fund with a lower yield.

What is an income trust?

According to Leslie Lundquist, “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.”

A look at taxation

Alan Wicks talks about how these funds create tax efficient income: “Trusts are very tax efficient because some of the income that is passed along to the investor is “Return of Capital”. Other types of income received from the trusts are Dividend Income and Interest Income. Return of capital is tax-deferred income and reduces the adjusted cost base of the unit that you purchased. Here is an example. If you bought a unit for $10.00 and then received a distribution of $1.00 which was return of capital you would pay no income tax immediately. However, when you sold the unit, lets say for $12.00, you would have a capital gain of $3 which is equal to the $12 you received when you sold minus the original cost ($10) less the return of capital ($1) you received”.

John Priestman adds, “After tax yield in these funds are double to quadruple yields provided by preferred shares.

How are income funds correlated to bond funds and equity funds?

Lundquist: “Income trusts as an asset class are too young to have a relevant history. The trust market has tracked the bond, high yield bond, stock and small cap stock markets at various times over the past five years. Over time, we would expect trusts to produce higher returns than bonds, but lower returns than equities, with higher risk than bonds, but lower risk than equities.”

Alan Wicks adds that his fund has displayed characteristics that are interest sensitive and thus income funds are more correlated to bond funds than equity funds, “The standard deviation of our fund is 3.1 vs the median of Canadian Equity Funds having a standard deviation of 5.5″.

A maturing asset class

Priestman thinks that the income trust asset class has been thoroughly tested, “these funds have gone through two interest rate cycles, the 1998 installment receipt debacle, management internalization, and a round trip in most commodities.”

Priestman adds, “Income Trusts have almost surpassed preferred shares as the largest equity income class in Canada.

What about REITs?

REITs offer slow, steady distribution growth with much less volatility than the commodity sensitive income trusts. According to Priestman who holds 45% of his fund in REITs, “Reits are trading with yields averaging 7.75%. Canadian REITs range from over 12% for hotel REITs to about 8.5% for apartment REITs. With these generous yields, we expect REITs to be a solid total return vehicles in 2001”.

What does the future hold for income funds?

Leslie Lundquist said it best, “After a few rocky years at the end of the 1990’s, trusts have come roaring back in 2000 and 2001. We believe that the trust market will grow over time, and that the number and type of trusts available will increase as the demand for income products increase. We have already seen a number of new trusts being issued this year, and we expect that there will be a moderate but steady flow of issuance going forward. As the trust market grows, the investment opportunities for our fund will grow, and we should be able to offer even greater diversification to our unitholders. We believe that the future of the trust market lies with those trusts not involved in oil and gas or real estate

My two cents

Income Funds are ideal for investors looking for stable, tax efficient income. They are a tremendous diversification tool for any portfolio. While trendy technology investments were flying high, these income funds were feeling the pinch. Today, income funds have rebounded to become one of the best asset categories despite the coming of the bear market.

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace.For more information you can follow him on Twitter @JimYih or visit his other websites JimYih.com and Clearpoint Benefit Solutions.

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