December 2006

Income trusts: a lesson learned?

Recently, Finance Minister Jim Flaherty abruptly put an end to the advantages enjoyed by income trusts. What now?

The news, which was broadcast after the markets closed on October 31, took everyone by surprise. It sent the income-trust sector into a tailspin, causing several securities to lose up to 40% of their value by the next morning. At end-of-week close, after a bumpy ride, the TSX income-trust index was off 14%.

The decision has been the subject of much discussion, in terms both of public finances and corporate taxation. For small investors who’ve seen their savings melt away in one fell swoop, however, the lessons are much simpler.

All investments involve a certain amount of risk

Basically, we must accept this phenomenon for what it is: another bubble burst. The fact that the cause was a government decision doesn’t change a thing: too many investors – too many small investors – bought these seemingly attractive vehicles in droves, without understanding the risks.

And who can blame them? After the dot-com fiasco of the early 2000s, the financial markets produced year after year of negative yields, and interest rates were at rock bottom. With returns often in excess of 10%, income trusts soon began to look like a miracle cure.

The thing is, in finance, miracles just don’t exist. And it’s important to remember the number-one rule of investing: the higher the potential return, the higher the risk. Period.

The importance of doing your homework

In any event, the income-trust sector has never needed government action to make investors cry in their beer. At the end of the 1990s, for example, during particularly difficult circumstances (rising interest rates, Asian economic crisis, etc.), the value of a number of income trusts plummeted by 40%. This instance was prior warning of the volatility of these vehicles.

Reading between the lines

With respect to the latest crisis, the very terminology involved may have misled more than one individual. “Income” and “trust” both convey a sense of security. Unfortunately, however, words are often deceptive, and these particular terms might have caused investors to forget that the value, returns, and distribution mix of income trusts are not guaranteed.

Accordingly, income trusts resemble stocks much more than they do fixed-income securities – a fact that Mr. Flaherty’s decision brought home hard.

Don’t buy if you don’t understand

Another aspect of income trusts made them very popular: their tax treatment for individuals. By making distributions that were often a combination of income and reimbursement of investors’ own capital, trusts fed the illusion that their returns were taxed less in the hands of individuals. An investment that brings in a yield of 15% while the markets are depressed and interest rates are a pitiful 2% – and, into the bargain, is only partly taxed? Let’s face it: it was too good to be true!

Income trusts conceal financial engineering techniques that are too complex for most small investors to grasp. What we’ve just seen only reinforces the wisdom of Warren Buffet, one of the world’s most eminent financiers, who advises investors to stay inside their “circle of competence” – i.e., vehicles they truly understand.