Income trust funds putting on a new face

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Income trust funds are undergoing a makeover as the deadline from the 2006 Halloween massacre edges closer.

Ottawa sounded the death knell for trusts with plans to tax them like common stock companies by 2011 - a move that has raised some anxiety about distribution cuts. Real estate investments (REITs) were spared.

Facing a shrinking investment universe, some funds have closed, merged or changed mandates. Others are diversifying into other income-producing securities, or plan to seek unitholder approval to make changes.

"Over time, today's income trust funds will have a hard time differentiating themselves from standard dividend funds," predicted Dan Hallett, director of investments at HighView Financial Group. "It's fine for somebody to buy them, but you should know going in that there are changes coming."

"In the first year or two following the end of the tax holiday, today's income trust funds may be worth holding because investee companies have tax pools to reduce or shelter distributions from tax," he said.

The Canadian Investment Funds Standard Committee defines income trust equity funds as those with 90 per cent invested in trusts, but it has relaxed the criteria for now.

Sentry Select Canadian Income and Norrep Income Growth Class are among those with flexibility in their original mandates so they have already started a new lease on life.

"We started to diversify early" so that trusts, including REITS, now make up about 48 per cent of the fund while the rest is in dividend-paying Canadian and U.S. stocks, said Michael Simpson, who manages Sentry Select Canadian Income. "Last year, we ... did well buying corporate bonds, but today we only have 1 per cent in corporate bonds."

He has 17 per cent in REITs and 14 per cent in energy names. Money is flowing into REITs because "they are the last vehicle in Canada that can distribute pretax cash flow to investors."

Alex Sasso, who runs Norrep Income Growth, said his fund is 65 per cent invested in income trusts, and the rest is in high-yielding bonds and dividend-paying stocks. "We are trying to find companies that can convert and not cut their distribution," he said. He is finding value in industrials trusts such as Wajax and Bird Construction.

Dynamic Equity Income changed its name in December from Dynamic Focused Diversified Income. The fund was originally conceived to invest 25 per cent each in energy trusts, REITs, business trusts and utilities trusts.

"We renamed the fund to better reflect equities securities that pay an income stream," said its manager, Oscar Belaiche. "Other than the 66 per cent in income trusts, we own banks, pipelines and corporations with a yield and that have good cash flow metrics."

The fund's prospectus will have to change this year as trusts convert because the mandate is to invest "primarily in income trusts and interest-bearing securities," he said.

Crescent Point Energy Corp., which converted into a corporation last year but still maintained its distribution, "is still held in our fund," he said. "The key is that we can hold businesses regardless of the structure, and as we move forward we'll have a diversified equity income portfolio."

Investors Income Trust Fund is one of two funds left with the word "trust" in its name. The fund is about 90 per cent invested in trusts, including 15 per cent in REITs.

"We have a strong representation in the oil and gas sector," said manager Jeff Hall. "We have focused on what we think are the companies that can sustain their distributions, and grow their reserves. Some names include Vermilion Energy, Baytex Energy, ARC Energy and Canadian Oil Sands. All of these companies have very respectable balance sheets," he said.

"We don't think the majority of our holdings are that vulnerable" to the tax change. "We have not had large exposure ever to the smaller-cap business trusts, and it's really there where most of the distribution cuts have been coming from."

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Income trust funds