The Federal Government’s tax fairness plan announced on Halloween 2006 choked off new issues of income trusts, infuriating investors who had bought the products for the high income they promised. But that doesn’t mean the trust sector is lacking in opportunities, product manufacturers say.

With no new income funds on the horizon, the focus has shifted to funds of income trust funds, which typically hold a diversified mix of energy, business and real estate income trusts.

And here, product makers say, all is not doom and gloom. Closed-end funds of income trust funds will continue to kick out steady streams of income up to and beyond 2011, when the tax treatment of income trusts changes. The expectation is that some will evolve into funds of high-paying equities as their underlying investments convert to corporate structures. Others may expand their mandates to allow managers to invest in non-income trust securities.

In any event, product manufacturers say, Ottawa’s decision to curtail trusts has not blunted strong investor appetite for products that generate income.

“Absolutely, there is a demand for funds that produce income,” says Garth Jestley, CEO of Toronto-based Middlefield Capital Corp.

David Roode, senior vice president at Brompton Funds Management Ltd. in Toronto, agrees. “There is a need for high-dividend-paying securities in the Canadian market,” he says. “Trusts were satisfying that need. In 2011, there will still be that need for income. Some trusts will convert, but some will continue to be what would effectively be high-dividend-paying corporations.”

Income-seekers don’t have a whole lot of choice if they want high-income-producing securities. Notes Joe MacDonald, executive vice president of Calgary-based Citadel Funds Corp.: “What’s your alternative? A GIC, a treasury bill or a 10-year Government of Canada [bond]? Investors will be behind in all of them. Investors will buy the funds based on yield.”

MacDonald’s suggestion is that advisors devote a small portion — something less than 10% — of a typical client’s assets to such closed-end funds: “They are a product that brokers should buy over time.”

Meanwhile, Middlefield’s existing portfolio of 16 closed-end funds of income funds continue to perform very well. “They deliver the distributions,” Jestley says.

Assets in those funds are invested “in the biggest and best of the income trusts,” he adds. “In our view, these are viable businesses that will be high-dividend-paying corporations if they don’t remain as trusts [after the 2011 deadline].”

The underlying businesses in the funds of funds “will be the grist for portfolios of income-producing securities going forward,” Jestley says. “It won’t come to an end in 2011.”

Consider Middle-field IndexPlus Income Fund, a listed closed-end investment fund that invests 50%-80% of its assets in a diversified portfolio of income trusts that tracks the S&P/TSX capped income trust subindex. The rest of the portfolio is actively managed within the income trust sector in order to enhance returns and reduce the risks associated with indexing.

The fund was launched in September 2003 with $345 million in assets. As of June 30, its top five holdings were: Canadian Oil Sands Trust (6.4% of assets); waste-management company operator BFI Canada Income Fund (4%); oil and natural gas funds Enerplus Resources Fund (3.6%) and Penn West Energy Trust (3.6%); and CCS Income Trust, which focuses on energy and environmental waste-management services (3.4%).

The fund has slightly underperformed the S&P/TSX composite index in the period from September 2003 to September 2007: on an annual basis, it has generated an average annual compound return of 16.4% vs 17.7% for the S&P/TSX. The fund is slated to mature on Dec. 31, 2014.

Thanks to the ability of closed-end fund issuers to raise new capital — through either rights offerings or exchange offerings — Jestley expects some closed-end funds will have their lives extended by unitholder votes. “They will morph from income trust funds,” he says, “into high-yielding equity funds.”

In the meantime, Roode notes, “[Income trust] yields continue to be good and you have another three years of attractive, tax-efficient income. As well, a number of the funds trade at a discount to their net asset values. So, you buy at a discount and you get paid an attractive yield, a level of income you can’t get anywhere else. Also, I think what happens in three years [when there will be a change in distributions as taxation of the trusts change] has been, to some extent, already factored into the price.”

@page_break@For those reasons, he says, “Over the next three years, there is some good value to be had.”

An example might be Brompton’s Stable Income Fund, which was formed in late 2002 with the aim of providing unitholders with a high level of monthly cash distributions, to maintain Standard & Poor’s SR-1 stability rating, and to preserve the NAV per unit. It has no fixed maturity date.

The fund raised $54 million in its initial public offering and a further $35 million in a follow-on financing in April 2003.

Since inception, it has posted an average annual compound return of about 13.7%. The fund trades at a small discount to NAV. Among its top holdings as of Sept. 30 were Davis + Henderson Income Fund, which supplies financial institutions with cheques and related products (7% of assets); Northland Power Income Fund (5.1%); and Innergex Power Income Fund (4.5% ). IE