Income trusts survived a roller-coaster ride in 2005. Despite limited-liability issues, interest rate hikes and federal flip-flops over fiscal policies, the hurdles were leapt and strong returns generated. Managers are confident of 2006 returns.

“The biggest issue was whether the trusts would be taxed,” says Matthew Baillie, manager of Sceptre Income Trusts Fund and managing director of Toronto-based Sceptre Investment Counsel Ltd. “But that risk is out of the way for the next couple of years with the Conservatives in power, although they have a minority government. I’m quite positive of this because a lot of the stars are aligned for the sector.”

As well as benefiting from a positive resolution of the tax issue, trusts should garner more attention because their inclusion in the benchmark S&P/TSX composite index will be completed in March. The addition should spark interest from pension funds and institutional investors who follow the index closely, he says.

“You will see another year of distribution increases, making it the sixth consecutive year, as the economy is pretty stable,” adds Baillie, noting that most of the increases are coming from an energy sector benefiting from strong global demand. “Interest rates don’t look to be a huge problem. There is always a worry about inflation, but China and India have cheap labour and exert strong disinflation forces. A strong Canadian dollar should also keep our bond rates fairly low.”

Valuations are priced against long-term bonds, and their roughly 4% yields express the markets’ confidence that inflation is under control, he notes.

Strategically, Baillie has allocated about 28% of the fund to oil and gas trusts, including service firms; 26% to real estate income trusts; 6% to utilities; 36% to business trusts; and 2% to cash. Strictly a bottom-up investor, he shuns the S&P/TSX income trust index, which has a 45% oil and gas weighting, saying such a large exposure is not prudent.

“We look for companies with high barriers to entry, low debt, low capital requirements, reasonable payout ratios and good management,” says Baillie. He likes to see some growth either through acquisition or internally.

One of his favourite holdings in the 50-name portfolio is Aeroplan Income Fund, an Air Canada spinoff. “It’s a real cash machine, with very low capital expenditures, a strong brand and an affluent customer base,” says Baillie. The trust has a 90% payout ratio and a 6% yield.

“One of the great things about Aeroplan is it can add new partners, such as retailers. It may add two or three later this year,” he says. Such a move would boost sales for its partners and attract more customers for the loyalty rewards program that has developed its own currency. “As the partners and customers grow, there’s more use of the points and more money for Aeroplan.”

Purchased this past October at about $13 a unit, Aeroplan is unchanged. But Baillie expects it to rise to about $15.40 a unit in the next year. “When management starts to add new partners, and people realize its business plan works, there will be interest in the trust,” he says.

Another favourite is Sleep Country Income Trust. The bed-and- mattress retailer has proven to be a winner, says Baillie. It has been growing steadily at 10%-12% a year, thanks to saturation advertising and an emphasis on service.

Acquired in 2004 at an average price of $15 a unit, it recently traded at $22 and yielded about 6.7%. Baillie bolstered the fund’s position in January, mainly because of the firm’s acquisition of Quebec-based Dormez-Vous, which it intends to expand aggressively to 25 stores from five stores by 2007.

“It has been very successful every time it has gone into a new area in Canada,” he says. “We think it can grow its sales 25% in the Montreal area in the next four years.” Baillie says unit price could rise about 10% in the next year.

Equally bullish is Oscar Belaiche, manager of Dynamic Focus + Diversified Income Trust and vice president of Toronto-based Goodman & Co. Investment Counsel. Like Baillie, he notes that this spring’s inclusion of income trusts in the benchmark index should be a positive factor.

“Index funds, insurance companies and pension plans may not necessarily include income trusts as part of their benchmarks today. But over time, they will gravitate toward them,” he says. “Trusts are becoming mainstream. The evolution we foresaw, that trusts would be part of the index, is becoming a reality.”

@page_break@As for threats, Belaiche says, rising rates could put upward pressure on the so-called “equity risk premium,” or the spread between cash yields and 10-year government bond yields. Such pressure could make investors look elsewhere, given a significant jump in rates. But Belaiche doesn’t anticipate such an event; he expects inflation will be moderate.

“I don’t see rates going up a lot or going down a lot. It’s more of a continuing range,” he says, noting long-term rates in Canada should range between 3.9% and 4.2%. Moreover, the U.S. economy is still producing jobs and consumers remain in a spending mood, even though the U.S. Federal Reserve Board has been jacking up short-term rates. “We’re in a sweet spot,” he says.

In the meantime, he believes return expectations will become more muted than in the past.

“Two years ago, everything went up. Last year, some trusts went up and some went down, but the overall market went up. This year, it may go up, but not to the same degree.”

Overall, he is positive on commodities and not concerned that rates will rise and create a shock. “But there are traps lurking for the unwary,” Belaiche says, noting that some weaker income trusts have slashed or even eliminated their distributions. “Some firms have the risk of underperforming, and some already have shown that.”

Belaiche describes his investment style for the 60-name fund as “quality at a reasonable price.” Although he has divided the income trust universe into roughly four equally weighted categories, there is an overweighted 38% in oil and gas trusts (including 7.4% in service companies), followed by 21% in business trusts, 19.5% in REITs and 12.5% in pipelines and utilities, with the rest in cash and preferred shares.

“We’re top-down in terms of allocation. We want exposure to each category,” he says. “But we want to overweight areas that have the best return potential — and resources have offered the highest potential.”

A favourite name is Canadian Oil Sands Trust, which has been in the fund since July 2001. “It has an investment in the oilsands that could have a 70-year reserve life,” he says. “It doesn’t pay a lot now, but its distributions will be growing and, depending on the underlying oil price, it could have more share price appreciation.”

Acquired at about $35 a unit in July 2001, it recently traded at $164. Belaiche expects the 2.7% yield to double in the next year or so as production comes onstream in 2007.

Another top choice in the resources sector is Fording Canadian Coal Trust. A major supplier of metallurgical coal to the Far East, the company converted to an income trust in 2002.

Belaiche acquired a position the following year at about $40 a unit. After splitting last fall on a three-for-one basis, the Fording trust recently traded at $46 a unit and yielded about 13%.

There were concerns that metallurgical prices could decline sharply this year, but Belaiche notes recent price settings were higher than expected. “There is an upside surprise that is starting to be factored in,” he adds.

The inclusion of income trusts in the broader benchmark will reduce the volatility that has affected the sector, which comprises many relatively small players, agrees Sandy McIntyre, lead manager of Sentry Select Canadian Income Fund and vice president of Toronto-based Sentry Select Capital Corp.

“Having more institutional involvement will dampen volatility. It will drive us toward better corporate governance, more stable business models, better balance sheets and a better definition of true distributable income,” says McIntyre, referring in his last point to the internal industry debate over the distributions issued by some firms.

A bottom-up investor, McIntyre — who runs the fund with Michael Simpson, a portfolio manager at Sentry Select — carefully scrutinizes balance sheets and determines the extent of leverage within each firm. “Our job is to determine when more capital is consumed than anticipated, which affects payout ratios,” says McIntyre. He and Simpson also conduct “stress tests” to find out how changes in operating margins affect distributions.

“There are issues such as seasonality and the receivables and payables cycle,” Simpson adds. “We want to make sure the company is not consuming too much cash in the course of a business cycle.”

Running an 84-name portfolio, of which 25 form the bulk of the fund, McIntyre has allocated 21.4% to the oil and gas sector, 5.8% to resources such as coal and lumber, 26.3% to business trusts, 21.3% to REITs, 12.8% to utilities and power-generation firms, with the balance in equities and cash.

In reference to the overweighted REIT position (the other sectors are underweighted or neutral), McIntyre says: “Real estate has shown a multi-generational ability to appreciate in value. While we don’t know what the highest invested use for well-located real estate will be 20 years from now, it will have a value equal to or better than today’s, barring a return to the Dirty ’30s.”

A favourite name is H&R REIT, a mid-sized provider of office and industrial buildings. “The firm specializes in matching a high-quality physical envelope with high-quality tenants. It puts together long-duration financing to match long-duration leases, with periodic steps in the leases,” says McIntyre. Acquired in 2002 at an average cost of $18.90 a unit, it recently traded at $22.30 with a 6% distribution yield.

The fund also holds Allied Properties REIT, which specializes in converting older buildings to office space. “Some people are attracted to the ‘glitz’ of the coupon, without buying the total package,” McIntyre says. “We buy businesses.” IE