Income trusts came roaring back last year as markets responded to policy actions by governments and central banks. But 2010 could be less rewarding — managers of income trust equity funds maintain the income trust market is fairly valued.

Still, some fund managers are looking for securities that have lagged the market or have yet to convert to the corporate structure. If income trusts do not convert by 2011, they will face higher taxes on distributions paid to investors.

“Things have changed to the point at which, generally speaking, valuations are fair or about average,” says Hovig Moushian, co-manager of Mackenzie Saxon High Income Fund and associate portfolio manager at Howson Tattersall Investment Counsel Ltd., a subsidiary of Toronto-based Mackenzie Financial Corp.

“We had a substantial decline in equities — income trusts included — and a decline in earnings, but nowhere near to the degree that prices had reflected. So, we had a recovery in prices and stabilization in earnings,” says Moushian, who shares fund management duties with Suzann Pennington, chief investment officer at Howson Tattersall.

The rebound is noteworthy for the change in multiples. For instance, business trusts are trading at 7.5 times enterprise value to earnings before interest, taxes, depreciation and amortization. A year ago, that multiple was around five times EBITDA. Real estate investment trusts saw spreads go as high as 10 to 11 percentage points over Government of Canada 10-year bonds. Today, the spread is around 4.4 percentage points. “Overall,” says Moushian, “we’re back to reasonable valuations.”

As far as conversion to the corporate structure is concerned (only REITs can continue as trusts after this year and be exempt from the taxation changes), Moushian notes that many income trusts have already done so and continue to pay dividends, or have announced their intentions: “Very few have completely eliminated dividends, and some pay closer to dividend yields of around 3%-4%, but others are 5%-7%. Much of the same is in store for the market come the end of 2010. Most companies will pay the corporate tax rate [upon conversion] and reduce their distribution by 30%, generally speaking. But all this has been largely digested by the market.”

From a strategic viewpoint, 62% of the assets under management in the Mackenzie Saxon fund has been allocated to income trusts, and 38% to common equities. The equities portion had been at 18% at the end of 2008, but the fund’s co-managers more than doubled it late last year.

“Given the impending tax [changes], our goal is to provide an attractive level of income to unitholders,” says Moushian. “With last year’s sell-off, it was an excellent opportunity to kill two birds with one stone — find inexpensive equities that had corporate structure and pay dividends.”

He and Pennington bought banks and utilities and some former trusts. There is 21.5% of fund AUM in energy companies, 21% in industrials, 5% in financials and smaller weightings in sectors such as utilities.

Running a 50-name fund, Mou-shian and Pennington like firms such as Contrans Group, formerly Contrans Income Fund. This trucking firm eliminated its distribution prior to its conversion to a corporation last year and then reinstated it, albeit at a lower rate.

“The payout is lower than what we would have liked, but the valuation is attractive and the business is improving,” says Moushian, adding that the 3.3% dividend yield could potentially rise to 10%. The share price is $7, although Moushian believes fair value is closer to $9.

Another favourite is Northland Power Income Fund. The utility will not become taxable until 2015 because the firm merged last year with an external management group and acquired tax offsets to permit tax-free status for five more years. The income trust is trading at $12 a unit, but Moushian believes fair value is $14 a unit.



There are still “pockets of opportunity here and there,” says Leslie Lundquist, lead manager of Bissett Income Fund and senior vice president with Calgary-based Bissett Investment Management Ltd.

Some of the attractive names are in the small-cap space, adds Les Stelmach, co-manager and vice president of Bissett. “A number of the large trusts, deemed to have stable distributions, have been bid up by investors,” says Stelmach. “People are looking for yield, and there are fewer opportunities than a few years ago.”

@page_break@Lundquist argues that good businesses will always be desirable, regardless of the tax structure: “That’s where we are seeing the opportunities. There are good companies that are viable and will continue to be excellent investments for the long term, but the change in tax structure is leaving the market wondering, ‘What happens to the distribution?’ And, in a larger sense, ‘What will happen to these companies?’ That uncertainty is keeping prices low enough that there are some attractive opportunities today.”

Thus, larger income trusts that have announced their intention to convert to corporations but maintain their distributions are fully valued, adds Lundquist: “They have been excellent investments, and we still own some. Their dividends will be stable. But the market already knows this. Where there is uncertainty — and, therefore, opportunity — is [among] some good companies, most of which are smaller firms. The market doesn’t care about the structure, but ‘What will they do with the distribution?’”

Lundquist and Stelmach have allocated about 90% of the Bissett fund’s AUM to income trusts, with 10% in common equities. On a sectoral basis, there is 26% in energy, 14% in real estate and 60% in business trusts.

“We want to invest in companies that have high and sustainable current income and reasonable valuations,” says Lundquist. “The bulk of the income trust market is where most of those names are.”

Pointing to Pembina Pipeline Income Fund, by way of example, Lundquist admits it is not cheap: “But it has announced that it will convert and maintain its distribution at current levels. We’re comfortable holding it.”

Running a 37-name fund, the co-managers favour smaller business trusts such as Badger Income Fund. That firm operates a fleet of more than 400 so-called “hydro-vac” trucks that use high-pressured water to dig utility corridors, among other things. “It serves a number of sectors, such as oil and gas or construction,” says Stelmach, adding that the firm garners about 60% of its sales in Canada and 40% in the U.S. “Wherever you might use a backhoe but are afraid of damaging something — that’s its niche.” Badger’s distribution yield is 8%. The unit price is $15.50, although Stelmach maintains it is undervalued. There is no stated price target.

On the large-cap side, the Bissett fund’s managers favour Enerplus Resource Fund. One of the oldest oil and gas trusts, this diversified firm has interests in shallow gas, oilsands, conventional oil and shale gas in Canada and the U.S.

“It has a very deep management team. But it has not participated in the run-up that other oil and gas trusts have seen,” says Stelmach, noting that Enerplus will probably convert to a corporation by yearend. “It used to trade at premiums to other energy trusts, but that premium has eroded. It just wasn’t generating the kind of growth that some other names did. These things go in cycles.”

But, Stelmach adds, “Enerplus has been rejigging its asset base and going after more growth-oriented plays that are also more techni-cally demanding. For now, though, the market is saying, ‘What have you done for me lately?’”

Stelmach says that Enerplus’s management has reiterated its commitment to being income-oriented. He notes that the trust is trading at six times enterprise value to debt-adjusted cash flow, vs 7.5 for comparable firms. The income trust is trading at $22.50 a unit and has a 9.3% yield.



Although energy names were the focus during the bear market, it’s time to pare back the exposure, says Jennifer McClelland, co-manager of RBC Canadian Equity Income Fund, and vice president and senior portfolio manager with Toronto-based RBC Asset Management Inc. Part of the change was the result of a new mandate last April, when the fund adopted the S&P/TSX composite index as its benchmark.

This was a reflection of the reality, as McClelland notes, that many large income trusts were converting to corporations. “Our energy weight is at the lower end of its range than it has been,” says McClelland, who shares duties with Brahm Spilfogel, vice president and senior portfolio manager.

“There has been some enthusiasm in some of the energy trust names, as they start to prove up their asset bases,” adds McClelland.

About 29% of the RBC fund’s AUM is in oil and gas, vs 27% for the benchmark, although McClelland notes the fund’s energy allocation includes 5% in pipelines. Other portfolio weightings include 21% in financials, 12% in industrials, 8% in materials, smaller weightings in areas such as consumer staples and 7% in cash. Currently, 45% of the invested portion is in income trusts and 55% in equities.

McClelland is more focused on buying a good business and less focused on the corporate structure: “Obviously, trusts have more income-type opportunities. But we are providing an income-focused equity fund, with diversified exposure across sectors. We’ve always had some equity exposure, but over time that has gotten bigger.”

McClelland and Spilfogel are active managers and like real estate firms such as Brookfield Properties Corp., a core position in the 60-name fund. “It’s a very high-quality real estate holding,” says McClelland, “with a focus on Manhattan and the bigger U.S. office markets, which have been ground zero in terms of investor pessimism for the past couple of years.”

Yet, the firm has benefited from long-term leases and has lately been able to secure financing. “It has turned a corner,” she adds. “There are signs that things [in the real estate sector] have stopped going down. Management has proven itself in making smart acquisitions. In terms of distressed opportunities, I like Brookfield vs some of the REITs.” Acquired last summer, the stock is $13 a share and pays a 4.7% dividend. McClelland’s 12-month target is $15 a share.

Another favourite is Algonquin Power & Utilities Corp., formerly Algonquin Power Income Fund. With 42 renewable-energy facilities and 12 thermal-energy plants, the firm “is well positioned to benefit from Canada’s growing focus on renewable power,” says McClelland.

She notes that the stock is trading at around six to seven times enterprise value times EBITDA, vs nine to 10 times for higher-quality peers. The discount is partly attributable to Algonquin’s external management contract and its decision to cut its distribution to unitholders last year when announcing plans to convert to a corporation.

“But it has recently internalized management,” says McClelland, who has no stated target for the stock. “And it has continued to create a diversified portfolio of renewable assets.” The stock is trading at $4.20 a share, and yields 5.9%. IE