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Stock Strategist

Introducing Canadian Income Trusts

Learn about the unique risks and benefits of these investments.

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International opportunities can be very enticing, but it's important to know exactly what you're getting into before you take the plunge. Morningstar is happy to announce that we are expanding our coverage of Canadian income trusts, and we wanted to help you understand this unique and increasingly popular investment vehicle. We recently initiated coverage on  Canetic Resources Trust  (CNE),  Enerplus Resources Fund  (ERF), and  Penn West Energy Trust  (PWE), and you might have heard that Canada's second-largest telecom,  Telus (TU), has also announced its intentions to convert into a trust.

What Exactly Is an Income Trust?
An income trust is a type of corporate structure used in Canada that allows companies to save on taxes by passing the tax burden to its unitholders via regular distributions. Income trusts have a wide range of names; sometimes they're called income funds, the oil and gas sector might call them royalty trusts or resources funds, and the real estate moniker is REIT (real estate investment trust).

Income trusts should NOT be confused with the types of income funds managed by mutual fund companies. Nor should they be confused with bonds or similar products. Your capital is at risk when you buy an income trust. Income trust prices fluctuate just like any stock.

But You Mentioned a Distribution�
Right. In this respect, trusts are similar to dividend-paying stocks. Trusts can issue distributions as frequently as every month, which makes them a favorite of investors seeking regular income. Canadian companies prefer using the trust structure because they can issue distributions out of pretax profits. This allows trusts to issue bigger distributions than they would as a traditional corporation. If they were to issue traditional dividends, they'd have to do it out of aftertax earnings.

What you have to remember is that these distributions can increase or decrease in turn with the trust's profits. This is why investors prefer trusts with steady, predictable cash flows from steady, predictable businesses.

Oil and Gas Is Steady and Predictable?
Commodity prices can fluctuate wildly, but some energy trusts actively hedge prices. And because their constantly depleting assets require significant investment to maintain production levels, the trusts try to mitigate some of the risk by investing in mature assets with lower rates of depletion. They still carry significant risk, which is why the market demands higher yields. Keep that in mind the next time you see a trust offering a 20% yield. There ain't no such thing as a free lunch.

What Caused the Boom in the Trust Sector in Canada?
It's a combination of factors, really. Trusts have been around for two decades now, but their popularity really exploded after the tech wreck and subsequent market downturn. Interest rates were low and investors wanted steady income. Many of those investors belonged to that mysterious demographic known as the baby boomers. And so--presto!--income trusts to the rescue.

It remains to be seen whether investor appetite will continue to be so voracious for these products. In a rising-interest-rate environment, capital may begin flowing to safer yield-bearing instruments. If trust yields have to rise to compensate, it would most likely come at the expense of falling unit prices.

What Are Some of the Other Risks?
The risks lie first and foremost within the business. Is it a stable, predictable business? If you're looking for steady income, boring is best. Will it require a lot of capital to maintain its business? We would prefer that it not. More capital expenditures mean less distributions to unitholders.

Take a look at the underlying business and you'll get a feel for what might endanger your distribution, and, consequently, the unit price. Increasing competition, rising costs, external threats like litigation or regulatory changes--these can all hurt profitability.

Then there's the possibility of regulatory upheaval. In September 2005, the Canadian government--understandably nervous about the tax revenues that it was losing out on--announced that it was considering changing the way trusts are taxed. The entire sector plummeted on the news. A fierce backlash led to the proposals being scrapped. Although trust prices recovered, it just goes to show how important regulations are to this type of investment.

Another remote yet potentially dangerous risk is that income trusts are not incorporated, and so unitholders could face unlimited liability through their ownership of trust units. However, Alberta, Ontario, and Quebec have passed legislation to protect unitholders in much the same way that common stock owners are protected from liability. But the legislation hasn't been tested in court, so it's something to keep in mind.

Are There Any Other Benefits to Owning Income Trusts?
Distributions, as previously mentioned, do not face double taxation as they do in the traditional corporate structure. This means bigger distributions. And in addition to these distributions, you can participate in a trust's growth through capital appreciation. In some cases, distributions themselves can be tax-advantaged (as what's known as a return of capital), but this really depends on the specific trust.

Trusts also benefit from a cost of capital advantage over traditional corporations. Because trusts are able to issue bigger distributions, they command premium valuations, and are able to issue equity more cheaply. This helps when it comes to making acquisitions or funding projects.

Other benefits relate to the specific types of trusts. Certain energy trusts allow purer exposure to commodity prices, as exploration risk is less of a factor. REITs enable the unitholder to invest in a diverse portfolio of real estate properties.

How Am I Taxed on Canadian Income Trusts?
This is general information and shouldn't be considered legal or tax advice--which is why you should contact a tax expert, or check with the income trust itself--but Canadian income trusts are usually considered corporations for U.S. tax purposes. Distributions to U.S. unitholders are subject to a minimum 15% nonresident Canadian withholding tax. If the trust units are held outside a retirement account, the withholding taxes may be used to offset your U.S. tax liability. If the trust units are held within a retirement account, then the withholding taxes may not be offset against your U.S. tax liability.

How Is the Morningstar Methodology Used to Value Income Trusts?
We value income trusts just like any other stock. The yield on the current unit price isn't as important to us as the long-term viability of the business. We take a look at what kind of free cash flows a trust can generate in the future, whether those are protected by an economic moat, and what kind of risks the business faces. Then we determine a fair value estimate, and our star ratings are generated by the premium or discount the unit price trades at with respect to our fair value estimate. A higher fair value estimate implies higher long-term cash flows, which, depending on what management decides to pay out, should mean higher or more-sustainable distributions for the investor.

 Canadian Income Trusts at a Glance
  Market Price* Fair Value Estimate Moat Rating Risk Rating Cash on Cash Yield 2006E Prod.**
Canetic Resources Trust  (CNE) $17.37 $11 None Average 14.1% 76,000
Enerplus Resources Fund  (ERF) $48.06 $42 Narrow Average 9.3% 84,000
Penn West Energy Trust  (PWE) $36.89 $29 Narrow Average 9.8% 114,000
*Prices as of 09-21-06
** boe/d

Kish Patel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.