[December 2006]

Since Ottawa deflated the income trust business with its move to begin taxing trust distributions in four years, there have been a lot of complaints from investors who were relying on those juicy tax-advantaged income streams. The challenge now for advisors and their clients is to create a healthy investment income stream, in what is still a relatively low inter-est rate environment, without income trusts to supercharge returns.

“There is no one magic answer,” says Dan Hallett, president of Windsor, Ont.-based Dan Hallett & Associates Inc. “Trusts will be around for the next four years, and many have dropped in price, to the point at which there could be some attractive yields. There are also dividend-paying stocks, high- yield bonds and real-return bonds. The key is to draw income from a diversified asset base — it could be a blend of different types of income, as well as capital gains.”

In fact, well-chosen trusts remain viable investments, says Bev Moir, senior investment executive at ScotiaMcLeod Inc. in Toronto. “What has been lost in the initial response is that there is a window of four years before any changes are implemented. Large, well-managed businesses with a history of stable distributions and the potential to increase them over time are still good investments.”

When income trusts start paying higher taxes, they will probably lower percentage payouts to investors; some will convert to corporations. The dividend tax credit on the distributions — which will be treated as dividend income — will pretty much compensate for drop in distributions, Moir says. Investors who hold income trusts in RRSPs, however, will not receive the dividend tax credit.

“As the dust settles, it will become more important where securities are held — whether in a registered plan, such as a RRIF or an RRSP, or in a non-registered plan,” Moir says. “Income that is tax-advantaged, such as dividends or return of capital, is best utilized outside a registered plan, while regular interest income can be sheltered from taxes only while it remains in a registered plan.”

Real estate investment trusts that derive most of their income from Canadian properties will escape the new tax rules and continue to offer attractive income streams. Their operations and property mix must be examined carefully, as they must have 75% of their holdings in Canada to continue to qualify as REITs, and 95% of their income must come from real estate, not related businesses such as nursing homes.

“Holders of regular income trusts have taken a big trimming, but the model isn’t dead,” says Barnaby Ross, vice president at RBC Dominion Securities Inc. in Toronto. “You can still build a good income portfolio with preferred shares and the better trusts that will survive and grow.”

Here’s a look at other options for income-seeking investors.

> Gics. Garden-variety GICs offer fixed rates of interest for a predetermined number of years. But there are also a variety of products with returns tied to various Canadian and international equity markets.

An equity-linked GIC offers a useful combination of guaranteed principal with the upside potential of stock exposure. The basic equity-linked GIC links its returns to the broad Canadian or U.S. stock indices, but others are linked to managed products such as mutual funds or a basket of securities that may include hedge funds.

Bank of Montreal, for example, offers a GIC linked to the performance of BMO Dividend Fund, a conservative equity mutual fund.

Often equity-linked GICs don’t offer the full return achieved by the underlying index or portfolio, so it’s important to read the fine print.

> Bonds. Bonds can be a useful portfolio stabilizer as well as an income source, but keep in mind that they fluctuate in value — particularly long-term bonds — creating the potential to make a capital gain or loss if they are sold prior to maturity. With bonds, yield usually increases with the level of risk, and higher income can be found by climbing up the risk scale from Government of Canada bonds to provincial, corporates and foreign bonds.

“With global bonds, you can take advantage of different interest rate cycles around the world, and can often find higher coupon rates and yields in the bonds of foreign countries,” says Elizabeth Lunney, senior vice president in the private client division of Franklin Templeton Investments Corp. in Toronto.

@page_break@Global bonds are an impor-tant component in Franklin Templeton’s Diversified Income Portfolio, and there are also a variety of pure global bond mutual funds from various sponsors.

> Preferred Shares. Preferred shares tend to pay higher dividends than regular common stocks. Good-quality preferreds can be found with yields of 5%-6% — and that’s before the benefits of the dividend tax credit. There are also a variety of closed-end funds that trade on the Toronto Stock Exchange and hold a portfolio of many different preferred shares, providing the investor with built-in diversification.

For example, Advantaged Preferred Share Trust holds 50 classes of preferred shares from 22 issuing companies.

Preferred shareholders are entitled to payment of dividends before common shareholders get anything. And a company must pay off all “cumulative dividends” — dividends in arrears — on preferred shares before it can resume paying common dividends. Most preferred shares are redeemable, which means the issuing company has the right to buy the shares back at fixed times and prices, which can be disadvantage.

> Dividend-Paying Stocks. Gavin Graham, chief investment officer at Guardian Group of Funds Ltd. in Toronto, says dividend-paying common stocks are also attractive, including those issued by the big banks, financial services companies such as Manulife Financial Corp. and Power Financial Corp. , and various utilities. Although the yields on higher-yielding commons are typically in the 3%-4% range before the dividend tax credit, these companies have the potential to increase dividends over time, which can significantly increase the yield ratio if it is based on the original price paid by the investor for the stock. If the dividend doubles over time, for example, a 3% yield would effectively become a 6% yield on the original price paid. (For more dividend-paying stocks, see page 52.) However, investors would probably also enjoy a rise in the market price of the stock as dividends rose.

“There are some attractive opportunities in both Canadian and global dividend-paying stocks,” says Robert Cassels, president of Toronto-based Cassels Investment Management Inc. and manager of Northern Rivers Monthly Income and Capital Appreciation Fund. “In many cases, there is enormous opportunity for these companies to increase the dividend payment, as only a small amount of earnings is being paid out to shareholders.”

IA Clarington Investments Inc. of Toronto recently introduced Clarington Global Dividend Fund, which is managed by Neth-erlands-based ABN-AMRO Asset Management. The fund gives investors access to a diversified portfolio of high dividend-paying stocks around the world. (Note that global dividends are not eligible for the dividend tax credit.)

> Income Mutual Funds. Rather than trying to manage individual securities, some of your clients may be better off holding income-oriented mutual funds that have a mixed bag of income-paying securities and pay regular distributions. Income can be derived from a mixed portfolio of dividend-paying blue-chip stocks, preferred shares, income trusts, and corporate and government bonds.

These vehicles are often designed to be tax-efficient by paying a large portion of the distributions as “return of capital,” which defers taxes until the investor redeems units of the fund. Income derived from dividends and capital gains is also tax-advantaged.

An example is Dynamic Dividend Income Fund, designed to hold 25% of its assets in four categories — preferreds, income trusts, bonds and high-yielding common shares. Managers can move as high as 40% or as low as 10% in any one category.

> Principal-Protected Notes. Many PPNs are designed to pro-duce income on a regular basis, and offer the additional benefit of a capital guarantee as long as the investor holds the note until maturity. Essentially, PPNs offer a guarantee on invested capital, with returns linked to an underlying investment such as mutual funds, hedge funds or stock and bond indices.

Fees for PPNs tend to be significantly higher than if investors directly held the underlying assets represented by the note, and they take a big bite out of returns. It’s not unusual for management fees on PPNs to run to 3%-5%, often with performance-based fees added. But PPNs can be a useful product for investors who want to participate in the upside potential of various investment options but don’t want to risk their principal.

Guardian Group of Funds recently introduced Bank of Montreal GGOF C.O.R.E. Protected Deposit Note High-Yield Bond R.O.C. Class, based on the performance of GGOF High-Yield Bond Fund. Unlike the underlying fund, which offers fully taxable interest income, the PPN’s distributions are in the form of return of capital, which defers taxes until the note matures in 7.5 years or is sold by the investor.

“For GIC refugees who have an aversion to securities that fluctuate in value and can’t bear any risk to their principal, something that tracks the growth of capital over time and offers principal protection can be a suitable investment,” Graham says.

> Annuities. Income annuities provide higher after-tax income than regular interest-paying investments because a portion of the income is considered return of capital. An annuity is purchased with a lump sum and is designed to pay a guaranteed income for a specified period, if it is a term annuity, or for the rest of your client’s life if it is a life annuity. When the client dies, the insurer keeps the value of the annuity and there is nothing left for heirs; a person with a long life gets better value from a life annuity.

However, different options are available, and some annuities allow benefits to be transferred to a surviving spouse. Others are insured income annuities that combine income payments over the holder’s lifetime with life insurance for beneficiaries.

“An annuity can provide an attractive return for life, but it’s not a liquid product and, once purchased, the principal amount is gone,” says Moir. “Annuities can be a nice component of an income stream, as it doesn’t matter what markets are doing because income is guaranteed.” IE



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