Will income trust conversions lead to yield chasing?

January 19th, 2010 | by admin |

In August 2008, I mused that the implementation of a 31.5% tax on previously tax exempt Canadian issued income trust would force many income trusts to convert to corporations before January 1, 2011 (the day the new tax regime is effective) and lead to distribution cuts in the range of 40-75%. In a January 15 research note, RBC Capital Markets noted that 35 income trusts have already converted to corporations. 22 of these conversions have been accompanied by a distribution cut with the average cut being more than 60%.

The act of conversion alone is not to blame for such a large distribution cut. Revenue and earning decreases in a down economy have only poured salt into the wound of income trust investors. As the drop dead date for the new tax regime looms, will increased income trust conversions lead to yield chasing by investors seeking alternatives?

Income trusts typically have higher yields than conventional stocks. For example, the long term adjusted funds from operations (AFFO) yield for REITS is historically at 8.1% (AFFO is considered a truer measure of a REITs cash flow). If investors, weaned on high income trust yields, decide to substitute income trusts for alternatives, will their baseline analysis be to other high yield products?

One hopes not for several reasons. As many commentators have noted, dividend growth is more attractive than dividend yield. Dividend yield is calculated as annual dividend paid per share/price per share. Thus, high yields are a function of high dividend payments, low share price or a combination of both which means the company has little room to pay out more or the expectations of growth are limited. This may not be a large factor for someone with a short investing horizon but it is important for long term investors who can increase returns by receiving constant dividend increases.

The other issue is what are the substitutes? The natural substitute is to move to a REIT (generally exempt from the new tax regime) but REITs are not value plays (at least in Canada; on the income side, Canadian REITs are paying out 94% of AFFO meaning do not expect large distribution increases) or are facing some serious short-term issues (American REITs suffering from increased vacancies and refinancing concerns where the asset already possesses a high loan to value ratio with the value continuing to erode).

The other natural substitute, dividend paying financial stocks, also have their well publicized issues. When JPMorgan Chase announced that its loan loss provisions in the last quarter have not significantly declined, it confirmed what many suspected. The banks are a long way out of the woods yet.

This is not to suggest that pursuing a high yield substitute is, in and of itself, a wrong strategy to pursue; for example, heavily regulated utilities tend to have high yields and some margin of safety given electricity is a necessity. However, a dogmatic chasing of yields could lead to trouble. The prudent approach is to find a balance between yield and growth and to wait out a large movement of cash out of converting income trusts to other high yield products.

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