Income trusts have existed in Canada’s capital markets for more than 10 years, yet there is still much we do not know about them, such as how they’ll perform in a hostile market or exactly what role they play in a portfolio.

We may be about to find out, however. A handful of academics and analysts are looking into income trusts to see how they behave and what they bring to investors’ portfolios over the longer term.

The products have long been controversial. Issuers and underwriters love the structure, and investors have largely embraced them. But income trusts have had their share of detractors. Governments have fretted over the trusts’ impact on tax revenue, and regulators seem worried about their disclosure practices, although they have done little to ensure greater clarity. Various market-watchers have voiced concerns about everything from the integrity of the income trust structure to retail investors’ understanding of their risks.

Some of the early worries about trusts have gradually been whittled away. Legislation has largely dealt with institutional investors’ initial concerns about the prospect of unlimited liability in the trust structure. A wide variety of companies have adopted the structure, so that trusts have come to occupy a large portion of the Canadian capital markets, easing their acceptance into the indices. Even the federal government’s tax worries appear to be mollified, for now.

One challenge trusts haven’t yet confronted is how well they perform when faced with significantly higher interest rates. The product’s popularity has flourished in an environment of low rates and scarce yields. With their promises of high payouts, trusts have been one of the few ways in which investors can garner dependable income in a low-rate world. The focus on the yield that trusts offer, however, may have clouded investors’ understanding of how to value trusts.

The fact that many investors buy income trusts primarily for their yield suggests they see the vehicle as a form of fixed-income. Yet analysts suggest that it’s important to understand that trusts are little different from traditional equities and subject to many of the same risks. Indeed, income trusts may face even more diverse risks than typical equities. If their critics are correct, the added risks include weaker governance, cloudier accounting practices and less meaningful disclosure. They may also offer less growth and create less value than a traditional public company.

For example, forensic accountant Al Rosen, head of Toronto-based Accountability Research Corp., has criticized trusts, saying many pay out more in distributions than they generate in net income. On the flip side, others have argued the trust structure provides investors with unique protection from foolish management. Because trusts return all or most of their cash flow to shareholders, income trust executives can’t squander the funds on ill-advised acquisitions or ego-driven empire-building.

The combination of fixed-income appeal, equity-like fundamentals and unique risk considerations suggests income trusts could be considered an asset class unto themselves. The prospect is appealing to investors who are looking to build efficient portfolios, as diversification is the surest way to achieve this. The emergence of a new asset class presents an opportunity for further diversification and, hopefully, for greater portfolio performance.

A diversified portfolio requires a collection of securities that tend to deliver uncorrelated returns; when one asset is lagging, another can pick up the slack.

Although there is plenty of data about basic asset classes such as cash, bonds and traditional equities, income trusts remain a relatively new and untested development. The returns they will deliver in the long term and the relationship of those returns to other asset classes is less clear.

A few academics are now trying to get a handle on this issue.

In an unpublished working paper, Sean Cleary and Greg MacKinnon, professors at the Sobey School of Business at Saint Mary’s University in Halifax, look at the performance of income trusts from the beginning of 1995 to the end of 2004. They conclude there is not much evidence that income trusts form a distinct asset class unto themselves. Rather, they find that they behave much like traditional equities.

“An examination of simple correlation coefficients provides little evidence that trusts are highly correlated with bond returns or with each other (as one would surmise if trust pricing was driven by investor sentiment),” the paper notes. “On the other hand, they display relatively strong and significant correlations with equity returns in general and with the relative subindex returns.”

@page_break@If that is the case, income trusts presumably don’t offer many diversification benefits over traditional equities. Cleary’s and MacKinnon’s paper, however, suggests that is not necessarily true, either.

“In spite of this relationship with traditional stock returns, our results suggest income trusts expanded the efficient frontier significantly over the 1995 to 2004 period, providing the opportunity to add value to well-diversified Canadian equity portfolios,” they write. “In other words, income trusts are not redundant, and do add value to an equity portfolio by enhancing the efficient set.”

Some of the portfolio-enhancing effect is because returns for trusts were so strong over that period, the paper notes.

The report doesn’t completely explain whether investors can continue to expect the added value trusts provided portfolios in the past.

The extent to which investors are willing to embrace income trusts for qualities other than their ability to generate income, such as added diversification and stricter management discipline, has yet to be tested. But that time may be coming.

A recent report by Toronto-based Genuity Capital Markets predicts that when income trusts are faced with rising rates and higher bond yields, their unit prices will suffer in the short term. The setback, however, may motivate investors to focus less on trusts’ yield characteristics and more on their other features because, although the yield appeal of trusts will certainly be hampered by rising rates, the other advantages of the trust vehicle will remain: tax advantages; the discipline the structure imposes on a company’s management; and possible portfolio diversification.

It remains to be seen whether investors value such qualities highly enough to keep the trust boom going. “Ultimately, the goal is to have investors view income trusts as tax-efficient equity vehicles with low to moderate growth and a high cash payment that provides a front-loading of total return,” the report notes.

The kind of trusts that should hold up best in a rising-rate environment, the paper suggests, are those with good growth prospects that can ramp up cash flow and, ultimately, their distributions.

In the short term, however, the reaction of yield-hungry investors could be to drive trusts’ prices lower than warranted. Should trusts become undervalued as a result, the Genuity report predicts, they could become targets of private equity investors.

“If income trust valuations fall disproportionately compared with those of corporations, private equity investors (or potentially even other companies) may step in and take the units private,” the report says, noting the kind of company that makes a good income trust — one with stable cash flow, low capital expenditures and the ability to leverage — are also qualities that appeal to private equity investors.

The Genuity report says the trust market will probably thrive in the long run, although it will have to be sustained by something other than investors’ appetite for yield.

“Our thesis is this: rising rates will cause rising yields and declining unit prices in the short term (and already have for most trusts in 2006). But the transition to traditional fundamental valuation metrics, driven by comparative valuation and new investor interest, will support the income trust market in the long term.”

Income trusts have been around for a decade and have acquired some of the trappings of capital market maturity, but they still have some growing up to do.

Trusts won’t become fully mature until they have weathered a tougher market climate, and investors have learned the best role these products can play in their portfolios. IE