Income trusts generated respectable returns last year, despite the reverberations of the ongoing liquidity crisis sparked by the U.S. subprime mortgage fiasco. Indeed, some fund managers remain cautiously upbeat about the asset class and focus on the distribution yields; some, however, are a little more wary.

One of those in the first camp is Leslie Lundquist, manager of Bissett Income Fund and vice president of Calgary-based Bissett Investment Management. Lundquist admits conditions are challenging. “The trust market will be affected by the broader market, and what’s on the top of everyone’s mind is the stress in the credit market,” she says. “We’ve also seen weakness in financial services institutions and ongoing uncertainty. With that as a backdrop, it’s hard for us to make a strong argument for price increases in trusts, unless we also see price increases in the broader market.”

Nevertheless, Lundquist argues that provided you are selective, there are still attractive distribution yields to be found in the sector: “We expect positive total returns from the trust market in 2008. But a lot of that will be made up mostly from distributions.”

Returns range from 6% to 12%. Noting that her own fund had a total running yield of 8.8% as of late December, Lundquist says: “If prices stay flat and you get 8.8%, how unhappy can you be?”

Even though Lundquist is allowed to own various income-generating asset classes, including stocks, bonds or preferred shares, she is fully committed to income trusts. “We are buying the best opportunities in the income trust market,” she says. “If we thought there were better opportunities, we would look elsewhere. So far, we’ve been very happy with trusts. Unless we develop perfect foresight and anticipate an absolute meltdown, we are more inclined to be in the market. Some companies will be in for a very difficult time, but others still have very good opportunities ahead. We’re carefully choosing which companies to own.”

About 25.7% of the Bissett fund is in oil and gas trusts, 14.2% in real estate investment trusts, 50% in business trusts and about 10% in utilities. The biggest strategic change in the past year has been the reduction in REITs, down from 20% a year ago.

“REITs started off very strong in 2007,” says Lundquist, who works closely with Les Stelmach, an income trust analyst at Bissett. “Everybody loved them, partly because they were exempted from the October 2006 tax announcement. And then they were being chased by investors. We brought our weighting down during the year and went into cheaper names, such as in the oil and gas trusts and many business trusts. There is better value in REITs today than a year ago, but, overall, we’d emphasis other types of trusts.”

One of the larger holdings in the 37-name Bissett fund is ARC Energy Trust. The firm is active in Western Canada and has a “diversified, quality asset base,” says Stelmach. “It also has a management team that has a proven track record. That’s important. You can have a wonderful suite of assets, but if you make poor financial decisions, you can cripple the organization in an adverse commodity environment.”

As ARC’s production is split between oil and gas, it has the flexibility to focus more attention on higher-margin oil production. A long-time Bissett holding, ARC traded recently at $20.50 a unit and yields 11.5%, slightly less than the 12.5% average yield for oil and gas trusts. What’s important, however, is the firm has been consistent in delivering its income stream.

“When you look at the oil and gas trusts overall, you always want stability,” says Lundquist. “ARC has offered that very well.”

Another key Bissett holding is Cominar REIT. Based in Quebec, the mid-sized firm is one of the largest landlords in the province and has a mixture of commercial, industrial and retail properties.

“It tends to be overlooked, partly because of its size relative to its peers and the fact that it’s located in Quebec,” says Lundquist. “We met management, looked at their properties and financial metrics, and concluded it is a very conservatively run operation. When you compare it to the senior REITs, it comes out looking very strong yet also cheap.”

Cominar, which was bought about a year ago, yields about 7.5%. “It’s not a screaming buy,” says Lundquist, who has no stated target for the REIT, which was recently trading at $17.40 a unit. “But it is very reasonable compared with other REITs.”

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The prospects are reasonably good, argues Rick Howson, manager of Saxon High Income Fund and executive vice president of Toronto-based Howson Tattersall Investment Counsel Ltd.

For one thing, the credit crunch has ended the flow of mergers and take-over activity by private-equity firms that had pushed prices straight up. At the same time, REITs have become more attractive. This past summer, the yield spread — the difference between 10-year Canada bond yields and REIT yields — declined to around 1%, vs a 4%-5% premium three years earlier. But in the past six months, the yield spread has widened to 4%. “Spreads are back to more normal levels,” says Howson.

But, from a valuation perspective, Hovig Moushian, assistant portfolio manager, notes that income trusts as a group are roughly where they were a year ago, with the exception of REITs.

“While REITs are not particularly cheap, they are more in line with the general income trust market,” says Moushian, “which is reasonably valued.”

The benchmark Scotia Capital income trust index is generating a 10% yield, or a premium of six percentage points over 10-year government bonds. In early 2007, the premium was 5.5%.

And there are individual names, regardless of the sector, that stand out. “There is no single sector overall in which we can find a ton of opportunities,” says Howson.

As value investors, the Saxon fund managers have an underweighted 7.5% in REITs (vs 13.1% in the index) and 22.6% in oil and gas income trusts (vs 40.5%).

“Oil and gas income trusts have been relatively expensive,” says Moushian. “It’s also not prudent to have such a large weighting in a sector that is so homogenous. It moves on the basis of two commodities that are highly correlated.”

Otherwise, there is 24.5% in industrial income trusts (vs 15.8%) and 26.4% in consumer products income trusts (vs 13.6%), as well as about 10% in dividend-paying stocks such as Royal Bank of Canada that offer a good total return based on growth potential and income.

One recent acquisition in the 45-name Saxon fund is ATS Andlauer Income Fund. A specialty trucking and logistics firm, it serves the health-care and electronics industries in delivering time-sensitive materials and products. “It gets paid a premium to ensure that it delivers products, such as new DVDs to video stores across the country,” says Moushian. Acquired last fall, ATS Andlauer was recently trading at $11.50 a unit and yields 9.8%. The managers have a target of $14 a unit, but within no specific time frame.

Another favourite is Stoneham Drilling Trust. An oil and gas drilling firm that serves Western Canada, it has new and efficient equipment that is in high demand. “In this environment, efficiency is highly prized,” says Moushian, adding that the firm has 19 drilling rigs. Stoneham also benefits from so-called “take or pay” contracts — in which the purchaser is obligated to pay the supplier (Stoneham) a minimum amount, even if the product or service is not provided. These contracts provide more financial stability than traditional “spot rig” operations.

Acquired this past summer at $17 a unit, Stoneham’s price recently has declined to $11.40 a unit. But the stock has two things in its favour, says Moushian: it yields 12.4% and “the current price is materially below what it would cost to replace the company’s rigs.”



But Tom Czitron, who oversees Sceptre High Income Fund, is one manager who has turned defensive. Since this past summer, the managing director of income and structured products at Toronto-based Sceptre Investment Counsel Ltd. has reduced the Sceptre fund’s REITs exposure to 15%, from a peak of 30% at the end of 2006. At the same time, because dividends have received more favourable tax treatment, Czitron has gradually raised the exposure to dividend-paying common stocks to almost 30% of the fund. There is also 22% in oil and gas trusts and smaller holdings in income trusts in the materials, industrials and consumer discretionary sectors.

“The REIT market in the U.S. had turned over in early 2007. So, we decided to lower our weighting in the Canadian REITs,” says Czitron. “The correlation between the two markets is quite high. People look at property on a North American-wide basis.”

Last fall, he also raised cash to about 20% but has since lowered it to around 7%. Most of that cash was allocated to stocks, oil and gas trusts and business trusts.

“Our value discipline was telling us to sell and we couldn’t find anything to buy [this past fall],” says Czitron. “So, we waited for trusts to get cheaper.”

REITs may continue to fall, he argues, “But, at some point this year, they will be a screaming buy.”

He is keeping an eye on U.S.-based REITs, as they have dropped in a significant way, but he is not quite ready to make a move.

One of Czitron’s favourite holdings in the 40-name Sceptre portfolio is Ag Growth Income Fund. A maker of corn-processing machinery, the firm has benefited from escalating prices because of growing demand for ethanol and feed for animals. “There’s a real shortage of corn, and people are not turning to other commodities,” says Czitron. “It’s a real boom.”

Ag Growth has a large market share in North America and an 18% return on equity. Bought about a year ago at about $18 a unit, it recently traded at $29.25 a unit and yields 5.4%. Czitron has no stated price target.

Another favourite is Allied Properties REIT. The firm redevelops and rents so-called Class I, or heritage, properties, primarily in downtown Toronto and Montreal. “We like the business model and management seems to execute very well.” says Czitron, noting that Allied Properties has about five million square feet under management. “It has done a great job in reconditioning its buildings.”

Acquired about two years ago when the REIT was $14 a unit, Allied Properties recently traded at $17.80, down significantly from its peak of $24 a unit in early 2007. “It’s a well-run company,” says Czitron. “We can probably add value from here.”

The REIT yields 6.7%. IE