Income trusts were a cornerstone investment in most monthly income funds, helping churn out cash distributions that collectively yield more in a year than bonds or high-dividend stocks. Now, however, investors stung by Ottawa’s reversal on trusts’ taxation are looking for other income-generating options.

One yeoman offering is TD Asset Management Inc. ’s $4.3-billion TD Monthly Income Fund, an established fund that has registered a first-quartile return over the past three years. After producing a strong 14% return in 2004, the fund was also a sound performer in 2005, posting an annual return of 13.4%. In 2006, the fund was up roughly 11.4%, producing a three-year average annual compound return of 12.9% — more than most funds in the “balanced income” category. It earned Canadian Income Balanced Fund of the Year recognition at the 2005 Canadian Investment Awards.

The TD fund is available in several series that target varying distribution levels. For the I series, detailed here, the fund’s distribution yield for the past three years has been roughly 3%. The fund is also available in T or H series, which typically target distributions of 6%-8%, largely achieved by returning a larger proportion of capital.

Compare the TD fund with National Bank Securities Inc. ’s younger $233-million National Bank Monthly Income Fund, another solid performer.

Up 11.1% in 2004, it delivered an attractive 14.9% in 2005. During 2006, it registered a more modest 8.5%, producing an 11.5% average annual compound return for the three years. The fund does not have a monthly distribution target, but it paid out slightly more than 4% to unitholders in both 2005 and 2006.

Both funds receive above-average risk-adjusted rankings from Morningstar Canada: the TD fund earns five stars; the NBS fund, four.

Following a brief stay with Bank of Nova Scotia as an equity analyst, Doug Warwick has been with TDAM for 23 years. He and co-manager Greg Kocik lean toward interest rate-sensitive companies with effective “moats,” strong yields and good returns on equity. The bond portfolio consists mainly of corporate bonds, with an emphasis on high-yield issues and little or no predictions on the future direction of interest rates. There are no preferred stocks in the portfolio.

Recently, about 42% of the TD fund’s holdings were in Canadian equities, with 30% in bonds, 24% in income trusts and roughly 4% in cash. This combination of assets is not static; the managers have made only a few changes since autumn, with a slight increase in equities over bonds. On the equities side, the fund is slightly overweighted in resources, financials and utilities, all areas in which the fund has been slowly increasing its exposure in recent months.

At the NBS fund, lead manager Marc-André Gaudreau is an assistant vice president with Natcan Investment Management and has eight years of investment experience. He’s responsible for all asset-allocation decisions as well as managing the fund’s preferred equities and high-yield bonds. TAL Fund Management Inc. veteran Virginia Wai-Ping is responsible for common equities and income trust assets.

Gaudreau typically makes gradual asset-mix shifts rather than adopting a tactical focus. The neutral asset mix for the fund is split among four asset classes: dividend-yielding stocks, income trusts, preferred stocks and high-yield bonds. Right now, the actual mix is 33% in Canadian common stocks, 12% in Canadian bonds, 17% in preferred shares, 19% in foreign bonds (all foreign currency exposure is hedged), 15% in income trusts and roughly 3% in cash.

On the equities side, the NBS fund is slightly overweighted in energy, financials and telecommunications.

What makes the NBS fund different is that it is one of very few with exposure to preferred stocks, a tattered market sector that offers managers little choice when choosing which issues to include in their portfolios — so much so that most income funds avoid the asset class altogether.

Preferred equity differs from common equity in that ownership of the shares does not represent ownership of the company. Rather, preferreds behave more like bonds because the shares represent a debt obligation owed to the investor. (See story on page 25.)

The recent reduction in the tax rate on dividends has boosted preferreds’ attractiveness, says Gaudreau. To match the after-tax return on preferred shares paying 5%, bonds would have to yield more than 7%.

@page_break@Despite the NBS fund’s emphasis on preferreds, there are still several common names among the two funds’ holdings, and many of their bigger bets are similar.

The TD fund holds about 80 stock positions, whereas the National fund holds about 130. The TD fund’s top 10 holdings account for roughly 36% of assets, whereas the NBS fund’s stake represents a mere 21%. Neither fund has any significant foreign stock holdings, although the TD fund did amend its prospectus last fall to allow for increased foreign exposure. The NBS fund does, however, have a significant portion of its portfolio in foreign bonds.

The conventional valuation ratios of both funds are quite similar. The NBS fund has a slightly lower price/earnings ratio and sports a lower average market capitalization. The dividend yield for both funds, at 4.7%, puts them in the category’s top quartile.

The TD fund is already quite large, so cash flow from inves-tors may become a problem, given the focus on large-cap, dividend-heavy stocks. Competitor funds have capped their offerings recently, limiting purchases to non-registered accounts.

Size, however, is not a factor at the moment for the NBS fund, which also offers an almost identical fund, Altamira Monthly Income, through a subsidiary.

Both the TD and NBS funds delivered less volatile returns than most of their peers. The NBS fund’s profile was the less risky of the two over the past three years. Both funds’ Sharpe ratios — 1.34 for NBS and 1.51 for TD — eclipse the median fund in the category.

Although both vehicles are solid offerings, the TD fund comes out ahead as its 1.45% management expense ratio is lower than that of about 90% of its category peers, including the NBS fund. As well, the TD fund offers a very attractive risk/return profile, a key element for conservative investors. On a monthly basis, the TD fund has beaten the risk-free rate of return more often than roughly 85% of funds in the category, Morningstar reports.

Yet the NBS fund is a worthy alternative, despite its higher costs. In all but one of the trailing one-year periods since its inception, the fund’s eclectic approach has beaten its benchmark, notes Morningstar. IE