Income Trust - Investor Risks

Investor Risks

Income trusts are equity investments, not fixed income securities, and they share many of the risks inherent in stock ownership, but often not the same rights and responsibilities, especially concerning corporate governance and fiduciary responsibility. Investors in Canadian income trusts cannot rely upon provisions in the Canada Business Corporations Act allowing for derivative actions and the oppression remedy, and often do not even have the right to elect a board of directors. Each trust has an operating risk based on its underlying business; the higher the yield, the higher the risk. They also have additional risk factors, including, but not limited to, poorer access to debt markets.

• Valuation: When distributions include return of capital the investor is receiving excess capital back from operations of the trust. A Trust Unit with high Return of Capital distributions will often attract a higher market value because the Return of Capital portion of the distribution is tax deferred until the unit is sold.
• Lack of income guarantees: similar to a dividend paying stock, income trusts do not guarantee minimum distributions or even return of capital. If the business starts to lose money, the trust can reduce or even eliminate distributions; this is usually accompanied by sharp losses in units' market value.
• Exposure to interest rate risk: since the yield is one of the main attractions of income trusts, there is the risk that trust units will decline in value if interest rates in the rest of the cash/treasury market increase. This risk is common to other dividend/income based investments such as bonds.

Interest rate risk is also present inside the trusts themselves on their balance sheets since many trusts hold very long term capital assets (pipelines, power plants, etc.), and much of the excess distributible income is derived from a duration mismatch between the life of the asset, and the life of the financing associated with it. In an increasing interest rate environment, not only do the attractiveness of trust distributions decrease, but quite possibly, the distributions themselves decrease, leading to a double whammy of both declining yield and substantial loss of unitholder value.

• Sacrifice of growth unless more equity is issued: because most income is passed on to unitholders, rather than reinvested in the business. In some cases a trust can become a wasting asset. Because many income trusts pay out more than their net income, the shareholder equity (capital) may decline over time. For example according to one recent report, 75% of the 50 largest business trusts in Canada pay out more than they earn. ("Who should you trust on trusts?". Financial Post. November 23, 2005. http://www.canada.com/national/nationalpost/financialpost/story.html?id=70faac90-a6c6-4315-a38f-b890b836838b.) However a PriceWaterhouseCoopers study indicated that contrary to opinions expressed elsewhere, Income Trusts were efficient at reinvestment in their businesses and added significant value for their unitholders.
• Exposure to regulatory changes: to the extent that the value of the trust is driven by the deferral or reduction of tax, any change in government tax regulations to remove the benefit will reduce the value of the trusts. See Canadian Income trusts below on how changes in Canadian taxation rules diminished market values.

Generally, income trusts carry the same risk levels as dividend paying stocks that are traded on stock markets. And since income trusts or dividend paying stocks sometimes pay out a portion of their profits every month, investors get the equivalent of a capital gain (in the form of monthly distributions) on their investment without having to sell their stocks.