[April 2007]

With interest rates low, stock markets volatile and many income trusts on the ropes because of pending tax changes, clients hunting for investments that provide steady income face a real challenge. Complicating the search is the desire of many clients to diversify their investments beyond Canadian borders.

One option is mutual funds designed to produce income. A large number of income-oriented funds introduced recently have a global focus, which could fill your client’s desire to take his or her portfolio for a stroll around the world.

“With an aging population, more people are looking to their investments to produce income,” says Brian Gooding, senior vice president of alliance distribution at Toronto-based Fidelity Investments Canada Ltd. , which offers an assortment of income-producing funds. “This group is conservative and wants predictable cash flow. With interest rates as low as they are, traditional interest-bearing products no longer meet clients’ needs. We’re in a new era, in which lifetime income planning is required.”

For many clients, global income funds can offer significant diversification by investing in a mixed portfolio of securities that could include regular bonds, corporate bonds, Canadian and global dividend-paying stocks, preferred shares, income trusts and common stocks.

Many of the recently introduced funds are designed to pay out a predetermined percentage of assets as monthly cash flow — typically 5%- 8% of assets on an annual basis. With returns from a variety of sources, including interest, royalties, dividends, capital gains and return of capital, the income stream is frequently much more tax-efficient than regular interest.

Burlington, Ont.-based AIC Ltd. recently launched two income-oriented funds with a focus on global investing and income production. AIC Global Premium Income Fund is designed to pay an annual income yield of 6%; AIC World Financial Infrastructure Income and Growth Fund, 5%.

The Global Premium fund invests in a diversified portfolio of dividend-paying companies that produce goods and services consumers require in all types of markets, including banking services, food and health care, says AIC CEO Jonathan Wellum. The dividend yield on companies based in parts of the world such as Britain, Europe and Australia is significantly higher on average than those on North American-based companies, he says.

AIC World Financial Infra-structure Fund focuses on businesses tied to the global movement of money, including banks, securities exchanges, brokerage houses, custodians and form processing.

“These companies participate in a financial toll road, benefiting from the fees charged on the buying and selling of financial assets and the movement of capital through exchanges, custodians and other intermediaries,” Wellum says. “Infrastructure development and growth of the global economy is not just about concrete highways; it’s about financial highways.”

For many clients, the best approach is often to build a blend of income from a diversified asset base offering interest, dividends and capital gains, says Dan Hallett, president of Windsor, Ont.-based Dan Hallett & Associates Inc. , and a fund can offer built-in diversification. When buying a fund that pays out a pre-set distribution, he says, it’s important that the distribution be reasonable in light of the fund’s performance. If the fund’s holdings fail to generate enough return to pay the targeted distribution rate, the fund could be forced to dip into capital to meet the targeted distribution or to lower the payout.

“Income funds have been a growing category in the past few years,” Hallett says. “It’s important that the distribution be set at a reasonable and sustainable level to reduce the possibility of whittling down the asset base.”

Guardian Group of Funds Ltd. of Toronto has also followed the global trend, introducing GGOF Global Dividend Growth Fund in February. The fund holds a diversified portfolio of 60 to 100 global companies, with no geographical restrictions. Although developed markets are favoured, the fund may invest up to 25% of assets in emerging markets.

Over the long term, dividend-paying equities have outperformed their non-dividend-paying counterparts, says Gavin Graham, GGOF’s vice president and director of investment. He expects much of the fund’s return will come from capital appreciation of well-managed, growing companies as well as dividends.

The fund comes in two versions — one that reinvests returns and another income-paying version that pays out 5% a year. Because only a small portion of the return is actually based on the dividends and most of it is generated by capital gains or return of capital, the income stream is tax-efficient.

@page_break@Graham points out that foreign dividends have some disadvantages relative to Canadian dividends, as there is no dividend tax credit on foreign dividends and a withholding tax is sometimes imposed. But companies with a steady dividend payment record tend to have good growth prospects.

“Global dividend-paying companies are an attractive asset class, based on their potential for superior returns with lower volatility,” Graham says. “They are an elegant solution to the difficulty of getting a reasonable level of income. Because of the dividends’ stabilizing influence, these funds can also be a portfolio anchor in the ‘exciting’ markets we’ve had lately, when there can be a flight to quality.”

Another new offering in the category of global income funds is Excel Income and Growth Fund, launched in January by Excel Funds Management Inc. of Mississauga, Ont. The fund invests in equity and debt securities around the world, including in emerging markets such as India, as well as more developed markets such as Australia and Germany. In India, for example, one-year treasury bills are yielding 7%. Other potential income holdings could include real estate investment trusts in Germany and Singapore, and Australia’s Macquarie Infrastructure Group, a major developer of toll roads. The fund will have a low correlation to North American markets, says Excel president Bhim Asdhir.

A risk with global funds is the unpredictability of foreign currencies, and this risk increases in emerging markets. When the Canadian dollar weakens against foreign currencies, the exchange rate differential can enhance returns on foreign securities. But the opposite is also true.

Because of the difficulty in predicting which way currencies will move, Criterion Investments Inc. of Toronto is offering a family of funds that includes currency-hedged alternatives. Among Criterion’s offerings is the recently introduced Criterion Water Infrastructure Fund, which comes in hedged and unhedged versions. The fund’s global portfolio is designed to produce an annual income distribution of 5%, investing in water suppliers such as large utilities, water-technology developers and packaged-water producers.

Criterion also offers Criterion Global Dividend Currency Hedged Fund, which invests in the 30 highest dividend-paying equities among the large multinationals that make up the FTSE global 100 index. That fund also pays an annual yield of 5%.

“If you’re not hedging, you’re taking currency risk,” says Criterion’s president, Ian McPherson. “You may get a headwind or tailwind from currency moves, but it’s often difficult to predict what it will be. Hedging allows clients the choice of taking exchange rates off the table.”

Short-selling is another way of protecting against risk in income portfolios. Arrow Canadian Income Fund, recently launched by Arrow Hedge Partners Inc. of Toronto, invests primarily in North American income trusts and dividend-paying common shares. Although it has a long position bias, it may also sell securities short if they appear poised to drop in value. The fund requires a minimum investment of $150,000, unless clients qualify as “accredited.”

For clients who want more diversification, an assortment of wrap programs offer one-decision investments focusing on income. Many have an element of global investing. Toronto-based AGF Funds Inc. offers AGF Elements Yield Portfolio, with a minimum investment of $5,000 and a 5% annual distribution paid monthly. The portfolio invests in a mix of funds, including AGF Canadian Bond Fund, AGF Global High Yield Bond, AGF Global Government Bond and AGF Dividend Income Fund.

Along the same lines, Toronto-based Franklin Templeton Invest-ments Corp. offers Diversified Income Portfolio for a minimum investment of $25,000. The portfolio holds six funds offered by the Franklin Templeton group. IE