Investor Alert: Income trusts

April 1, 2006

What should I know about income trusts?

If income trusts are a bit of a mystery to you, but you want to invest because you have heard great things about them, then at the very least know these three facts:

  • Income trusts are not fixed income investments
  • High yields are not always a good thing
  • You may already own income trusts through your other investments

Understanding these facts can help you identify some of the risks of investing in income trusts. Knowing the risks of an investment before investing is one of the key elements to making an informed investment decision.

Income trusts are not fixed income investments

Is there a guarantee that I will receive payments from an income trust? No. Although you may expect income trusts to make payments to their investors, there is no guarantee or obligation for them to do so.

Why would an income trust stop making payments? An income trust will generally stop making payments, also known as distributions, when it does not have enough money to run its business.

An income trust, sometimes called an income fund, is a trust that owns an interest in a business. The idea is that the business will generate income from its operations and pass this money on to the trust. The trust will then distribute the money to its investors. However, the business needs a minimum amount of money to maintain its operations. If the business cannot make or borrow this minimum amount, then it will have to decrease or stop its payments to the trust. This will result in a reduction or suspension of distributions to investors.

Has this ever happened?

Yes. Some trusts have encountered this problem and have suspended payments to their investors.

What happened to their investors? Some investors lost money on their investments because when the income trust suspended payments to investors, that resulted in a drop in the income trust’s trading price on stock exchanges. Investors not only stopped receiving distributions from these trusts, but the market value of their investments also declined.

How can I avoid this risk? You need to determine an income trust’s ability to continue to make distributions to investors by getting answers to these questions:

Can the business make enough money to sustain itself, grow, and make distributions to investors? If it can, how much money can it reasonably be expected to distribute to investors? To get the answers you have to assess the strength of the business held by the trust by researching its business operations, its industry, and market trends that may affect it.

Can someone help me with this?

Yes. You can ask a qualified registered advisor to help you answer these questions. Just make sure you understand the answers before you invest. Otherwise, you may be risking more than you know.

High yields are not always a good thing

What is a high yield? An income trust is considered to have a high yield if it pays an above average return to its investors.

How is that not a good thing?

It is not good if the income trust cannot afford the size of the payments.

A trust that pays an above average return, a high yield, to investors may actually be in trouble because, in the end, it cannot afford to sustain such payments. A trust that distributes more money than its business earns, or that its business needs to sustain itself, is likely distributing borrowed money to its investors. An income trust that continues to operate like this puts the health of its business at risk.

Why would an income trust pay a high yield if it cannot afford it? An income trust may be using high yields to attract investors rather than using the yield to reflect how well or poorly its business is actually doing. High yields that jeopardize the operation of an income trust’s business put the trust’s long-term health at risk, which puts investors’ money at risk.

What can I do to avoid this risk?

To determine if the income trust’s distributions are putting its health at risk, you need to get answers to the following questions:

How is the trust funding its distributions to investors? Is it money that the business earned that remains after paying the business’ maintenance costs?

If not, then how long can the trust continue to make the distributions before it jeopardizes the operations of the business?

Can someone help me with this?

Yes. You can ask a qualified registered advisor. They may need to dig deep into the financial statements of the income trust and its business to answer these questions. The formulas income trusts use to calculate what money makes up the distributions to investors, also known as distributable cash, can be very confusing because there is no set standard for the calculation. However, it is worth asking your advisor to do this. If you invest in an income trust without knowing where the distributable cash comes from, then you risk investing in a business that is not sustainable.

You may already own income trusts through your other investments

How might I own an income trust without knowing it?

Income trusts have become so popular that mutual funds of all sizes and types invest in them. If you own mutual funds, then you may have more invested in income trusts than you think.

Why does this matter?

If you buy an income trust without first knowing how many income trusts you already own through your other investments, then you risk having too much money invested in them. Having too much invested in one type of investment means you will lose more of your money if that type of investment performs poorly. If this happens and you are unable to sustain such a loss, then you were probably over exposed to that type of investment.

How do I avoid this risk?

Investing in multiple types of investments is known as diversification. Diversification is an accepted strategy for minimizing the risks of over exposure. If one of your investments performs poorly, then proper diversification can help minimize the impact on you.

Can someone help me with this? Yes. You can talk with a qualified registered advisor. They can help you determine your investment goals to ensure that you are not over exposed to the risks of income trusts. Investing in income trusts before knowing your exposure to them through other investments can put your money at risk.