The downside of income trusts

Tom McFeat discusses the less-reported side of income trusts:

Some investor advocates are worried that many holders of income trusts aren’t fully aware of the risks. Income trusts, after all, are all about the income. Their unit prices rise and fall on the health of that distribution. And when they fall, they can fall hard.

Take the case of FMF Capital. It generates sub-prime residential mortgages in the U.S. and then sells them to institutional loan buyers. But interest rates have been rising in the U.S. lately. That has reduced the premiums it receives. The cash available to distribute has shrunk. So on Nov. 15, the company suspended its distributions indefinitely. The price of FMF Capital units plunged 77 per cent. In one day.

And there are other concerns. Just hours before Goodale put an end to the income trust review, a group of forensic accountants came out with a report that questioned the financial reporting, the valuations and the aggressive marketing of many trusts.

Accountability Research Corp.’s main targets were not resource or real estate trusts – many of which have been around for decades. Their biggest concern lies with the newer business trusts. They looked at the 50 biggest business trusts and found that, on average, a significant portion of their cash distributions (more than a third) were not actual income from the business, but were simply a return of the investors’ own money.

The public debate about income trusts has thus far been framed by the people who have thus far made plenty of money off of those trusts, and who surely want that success to continue. And it's tough to fault the investor groups for succeeding in shutting out the opposing viewpoint. But the one-sided debate has left some important considerations out of the public sphere.

For all the talk about how retirees desperately need the higher rate of return associated with income trusts, little attention has been paid to the associated risk. And that risk looks all the worse if many income trusts are viable in large part only due to continued investment. If indeed more than a third of cash distributions are based purely on investors' money, that suggests that the projected rate of return should be slashed significantly to compensate for the purchase rate stabilizing in the future.

Of course, this will all likely be ignored now that Goodale has rendered his verdict. In the meantime, all investors now relying on income trusts should keep in mind what they say about things that seem too good to be true.