Prospects for canada’s income trusts have vastly improved now that the uncertainty regarding possible taxation has been put to rest. For now, anyway.

The no-taxation environment isn’t likely to last forever, warns Wui Seng Kon, a Toronto-based business trust research analyst at Wellington West Capital Markets Inc. He says that while Finance Minister Ralph Goodale’s about-face has meant the sector has dodged a bullet in the short term, he thinks trust taxation is inevitable in the long run. “Otherwise, it’s tantamount to saying the government is OK with zero corporate taxation.”

But that’s in the future. It will probably take several elections and a majority government before it happens, says Kon, whose two favourite trusts among the dozen covered by Wellington West are Aeroplan Income Fund and Gateway Casino Income Fund.

The sector hit a new 52-week high at 170.4 in the first week in December vs 143.3 just after Goodale’s announcement that trusts would not be hit by new taxes.

Now the sector’s players hope the focus can remain where they believe it should have been all along: which income trusts are right for investors’ portfolios.

Over the past year, the trust universe has divided into two categories, high- and low-caliber, says Bob Gorman, Toronto-based vice president of managed investments at TD Bank Financial Group. Investors should be on the lookout for trusts with stable and sustainable distributions that can support their share prices.

“The lower-quality issues came to market in this environment where trusts were being bought willy-nilly. Many of them had very aggressive targets for the income they would pay to unitholders, but those targets were too optimistic in some cases. The lower-calibre trusts have had real problems. Two dozen of them have cut their distributions and they are being punished by the market. That trend will continue over the coming year,” he says.

TD is bullish on a number of trusts, including RioCan Real Estate Investment Trust, H&R Real Estate Investment Trust, Canadian Oil Sands Trust, Bonavista Energy Trust, Arc Energy Trust, Livingston International Income Fund, Yellow Pages Income Fund and BFI Canada Income Fund.

Both Gorman and Gavin Graham, Toronto-based vice president and director of investments at Guardian Group of Funds, say there is no universal response from the trust sector to the likelihood of a slow but prolonged rise in interest rates because trusts in certain sectors are more sensitive to rate changes than others.

For example, Gorman says, trusts most likely to be affected by the actions of the central bank are in utilities, such as Enbridge Income Fund or Altagas Income Trust, or those marketing hydro electric power, such as Algonquin Power Income Fund or Great Lakes Hydro Income Fund.

Real estate investment trusts would see some movement in their prices, but not as much as the utilities. Indeed, Graham thinks higher interest rates should not be seen as bad for property. “If you think why rates are going up, it’s because the economy is doing better. That means more tenants, lower vacancy rates and tenants paying higher rents. In fact, REITs are more economically sensitive than interest-rate sensitive.”

General business trusts are less affected because they respond like stocks to interest rate hikes. The category least sensitive to interest rate hikes is energy and natural resources trusts.

Al Rosen, a forensic accountant with Accountability Research Corp. in Toronto, says while interest rates are a factor, the more important consideration is how so many less-than-exemplary companies are being turned into trusts and “getting dressed up in a fancy new gown to completely disguise their real nature.”

Rosen says the way in which many trusts describe their return is particularly troublesome. “They keep on quoting a yield of, say, 12%. But you find through analysis that the net income is 7% and 5% is the return of their own money. You’re only getting 7%. The other 5% is hot air.”

This has lead to unrealistic valuations or a pricing bubble in Rosen’s opinion. However, James Gauthier, an investment funds analyst at Dundee Securities Corp. in Toronto, disagrees. “A bubble suggests we’re dealing with a certain level of absurdity in the pricing of the asset. But like any asset class, trusts can be expensive or cheap. I wouldn’t say they’re dirt cheap but there might be some good opportunities. After the government came in [during September], the sector was beat up by 10%-15% and money that came in after that has been rewarded,” he says.

@page_break@If you want to determine if a particular trust is a star or a dog, start by looking for stability, Graham says. “Boring is good. You want the Yellow Pages or BFI. If it’s restaurants, trucking or a pulp mill, the last time we checked, those were pretty volatile businesses,” he says.

He adds that an excessive payout can be another red flag. Paying out between 85% and 95% of distributable income is perfectly reasonable, he says. When it gets close to 100% and there’s little room for error, however, alarm bells should be going off. “You get what you pay for if the yield is high. It’s reflecting the chance they might cut or suspend the payout, which is why oil and gas trusts have the highest yields and REITs have the lowest.”

Advisors have to be prepared to do their homework on trusts, Rosen says. Many advisors don’t understand accounting and financial reporting. “They just go on rumours from around the office.”

Over the past five years, underwriters have earned $1.44 billion in the trust sector and that is on top of brokers’ commissions, Rosen says. “There are huge dollars involved. As long as there are suckers out there to buy the things, they’ll be tempted to take anything and turn it into an income trust.”

Rosen cautions investors to search out trusts with good track records over three to five years. If a trust is constantly generating a certain level of distributable cash with little variation and it has good management, it’s almost like a bond, he says.

Others, such as Jazz Air Income Fund, are in volatile industries with plenty of competition and do not have a lengthy history. “What’s going through your skull to make you buy that?” Rosen asks. IE