With interest rates still at rock-bottom levels, financial advisors with clients seeking income are finding attractive opportunities in income trusts.

“Many income trusts are in the process of converting to corporations, and there are some exceptional opportunities as this area is misunderstood,” says Barnaby Ross, vice president with Toronto-based RBC Dominion Securities Inc. “There is a hunger, an overwhelming thirst for income, and many income trusts are providing a solution.”

Income trusts have been in purgatory since Ottawa announced on Oct. 31, 2006, that those business entities would no longer be exempt from paying taxes on the income they flow out to unitholders. Instead, income trusts will be taxed like regular corporations beginning in January 2011, but have until 2013 to convert into corporations.

Although real estate investment trusts can maintain their current structure, the announcement immediately created a cloud of uncertainty over the business trust market, which then darkened during the market decline in 2008-09.

But income trust mutual fund managers, many of whom are seeing their funds convert to more broadly based income funds that can invest in a wider variety of yield-oriented securities, say the confusion and negativity have led to opportunity. Many income trusts have either already converted or are in the process of converting to taxable structures that will pay dividends.

Although some of the new entities will be paying dividends that are not as high as the distributions they were able to pay as income trusts, due to the effect of taxes on their available cash, former income trust investors who hold these newly formed corporations will be able to take advantage of the dividend tax credit. In many cases, the dividend tax credit will offset the cuts in distributions.

“You want to make sure the stated dividend is sustainable in relation to the company’s ability to generate cash flow, as well as the general economic cycle,” says Scott Lysakowski, vice president with Phillips, Hager & North Investment Management Ltd.in Vancouver.

Although some trusts will be cutting their investor payouts, others will not, says Jason Gibbs, portfolio manager with Dynamic Funds Ltd. in Toronto. Some had a low payout to begin with and therefore have elbow room to maintain the same payout in the form of a dividend. In addition, some income trusts have tax pools they can carry forward after they convert to corporations, and — for a few years, at least — they will be able to shelter some of their income from taxes and therefore have more to pay out in dividends.

Leslie Lundquist, co-manager of Bissett Income Fund in Calgary, which is sponsored by Toronto-based Franklin Templeton Invest-ments Corp., says more than 90% of her fund is in income trusts — and that’s where she sees opportunities.

“For a long time, nobody wanted to look at income trusts,” Lundquist says. “Everyone knew they were going away soon and, therefore, abandoned them. Because they’ve been overlooked, we are finding a lot of good values in this space.”

There are now about 170 income trusts, down from a high of 248 in 2006. Lundquist says the best values are in the smaller-capitalization business trusts, which have been overlooked by analysts and are too small for institutions to own.

Lundquist expects the wave of upside will come as those income trusts that have not yet converted or announced conversion plans tell the market their plans: “In many cases, the cuts won’t be as bad as people expect. Investors will be looking at a good company going forward — and the uncertainty has been removed.”

Sandy McIntyre, senior vice president and chief investment officer with Sentry Select Capital Inc. in Toronto, says he has been seeking income trusts with strong balance sheets and low payout ratios, which give them a margin of safety should they fall upon tough times.

“We like companies with the ability to grow their dividends or distributions,” McIntyre says. “The best investments are those that can grow the direct return to shareholders, which is the dividend or distribution. Those are real.” IE