Understanding the Euphoria Surrounding Income Trusts
As of March 2004, there are 137 income trusts that represent a market capitalization of $89.2 Billion. This represents a 5-fold growth since the beginning of the new millennium when we started the year with 58 trusts making up to $18.2 billion dollar market capitalization.
Why are income trusts so popular?
There are many reasons why trusts are so popular today
- Performance versus stock markets. Without question, one of the most important contributors to the euphoria of income trusts is the past performance. In relative terms the income trusts appeal infallible against an incredible depressing bear stock market. In absolute terms, the income trust index has incredibly impressive returns over a 1 through 8-year period.
1 year 2 year 3 year 4 year 5 year 6 year 7 year 8 year Scotia Capital Income Trust Index 38.30% 25.30% 24.70% 25.60% 22.10% 14.00% 12.30% 14.90%
One word of caution – chasing performance does not work and everything goes in cycles. Be careful about buying only for the recent performance euphoria.
- Demographics. The aging population is contributing to more income and safety focused objectives. Today one in 10 Canadians are over the age of 65. Over the next 25 years, 1 in four Canadians will be over the age of 65. As the population gets older, the demand for income products should grow.
- Income. In a world of uncertainty, investors are finding some comfort in the fact that some investments provide a regular steady flow of income. Income trusts are designed to pay this stream of income. Investors today like the notion of getting something back from their investment unlike stocks where returns are purely predicated on movements of price.
- Taxation. Not only do income trusts provide a regular stream of income but they do so in a very tax efficient manner. When you compare this tax efficiency to other assets, they propel income trusts into a new light.
Are income trusts overvalued?
The contraries tend to look at income trusts and the euphoria and back away. Many argue that income trust are overvalued. According to John Priestman, manager of the GGOF Monthly High Income Funds (one of the biggest income trust funds in Canada), “there are definitely some signs of overvaluation. After a great run, consolidation is appropriate and inevitable.” Priestman believes that there is a tug of war between excellent fundamentals and historically high valuations. He continues, “We are holding higher than normal cash values but it is not necessarily due to a bearish perspective. We have taken some profits and look to add to positions on pullbacks.”
Hang in through volatility
Priestman further urges investors to hang in through periods of volatility. “The fundamentals are still very strong and there are some significant issues ahead that could create significantly more demand.”
- Trusts remain unexploited by both domestic and foreign institutional investors. Institutional and international demand is in its infancy.
- Bondholders may start to look at income trusts as an alternative asset class. Over the past few years, it has been equity investors that have moved into the income trust market. In the years ahead it’s retail demand could come from a completely different investor.
- If pension plans can get over the limited liability issue, pensions could create one of the biggest demand booms ever.
Why should you consider income trusts in your portfolio?
Income trusts have become an asset class on their own. Their primary objective is to provide a regular stream of tax efficient 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 goes to unit holders. 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 unit holders.
In general, an income trust should represent the income portion of a portfolio. It is not designed as a growth vehicle despite some of the more recent returns. In fact the recent returns may be a sign that the price of income trusts may have gotten a little ahead of themselves.
Trusts are a good investment for people who have already accumulated their retirement assets, and who now wish to live off of them.
My two cents
My message is simple – proceed with caution. It mirrors some of my words back in early 2000 with respect to technology. With euphoria often comes some level of risk. Investors are enamoured by this asset class and based on the fundamentals, they should. That being said, I think more than a few investors are buying income trusts for the wrong reasons. When in doubt, remember some old principles of investing like diversify your holdings, be informed before you buy and understand the risks of investing.