Income trusts in transition

The average annual total return of the S&P/TSX Composite Index for the 10 years to the end of September was 4.1%, versus 15.4% for the S&P/TSX Income Trust Index. As at the end of September, the dividend yield on the composite index (which includes income trusts) was 2.6% versus the distribution yield of 7.5% for the S&P/TSX Income Trust Index.

For the most part, says Gibbs, "it is the mature businesses that are able to generate the steady and rising cash flow necessary to consistently pay high levels of distributions or dividends to investors."

The utilities sector, which is defensive in nature, is an important source of opportunities. Power companies or trusts, for example, have long-life assets and contractual cash flows, secured, in many cases, by government contracts. "The main risk to these trusts or stocks is increasing interest rates," Gibbs says. There is also "a need for investors to ensure that the assets are operated properly."

Gibbs says many income trusts have already successfully converted to corporations or have announced plans to do so. This is in response to the new taxation regime for most publicly traded trusts (other than qualifying real estate investment trusts, or REITs), which takes effect in 2011.

	Income trusts outperform broader market
	Index	1 year	3 year	5 year	10 year
	S&P/TSX Income Trust	24.7	6.0	4.9	15.4
	S&P/TSX Composite	11.6	-1.4	5.2	4.1
	For periods ended Sept. 30 Source: Morningstar

Goodman & Co. manages the Dynamic stable of mutual funds. Gibbs is a senior member of Goodman & Co's equity-income team, which is responsible for a range of funds whose assets total approximately $6 billion. They include Dynamic Equity Income, Dynamic Strategic Yield and Dynamic Global Infrastructure, of which Gibbs is the lead manager.

Dynamic Equity Income, which was launched in July 2001 and is managed by Gibbs's colleague Oscar Belaiche, has assets of more than $1 billion. As at the end of August, this fund's yield was 6.5%. Its three biggest sector weightings were energy, real estate and utilities. Some 62% of the fund, which had 42 holdings, was in income trusts.

In stock or trust selection, the equity-income team looks for businesses that are "best in class." The team's discipline is to "invest in quality businesses at a reasonable price," says Gibbs.

Jason Gibbs

A utilities trust in Dynamic Equity Income's top 10 holdings and one that is also held in other portfolios managed by the team is Northland Power Income Fund NPI.UN. The trust, which has a market capitalization of $1.1 billion, is slated to convert to a corporation to be called Northland Power Inc. on Jan. 1, 2011.

Northland develops and operates power-generation projects mainly in Ontario, Quebec and Saskatchewan. Its assets are natural-gas-fired plants and its sales are mostly under long-term contracts with an average duration of 13 years. Management under the helm of John Brace, who has been with Northland since 1988, is "experienced in this field and highly disciplined," says Gibbs.

Northland Power is currently developing a range of new projects. "These are testimony to its success in winning contracts." These projects, Gibbs says, involve substantial capital expenditure, which could limit cash-flow growth over the short term. "But this is expected to rebound over the next several years."

Northland's distribution yield is 6.96%. Quebec-based Innergex Renewable Energy Inc. INE offers similar investment opportunities, says Gibbs. This stock is held in a number of equity-income portfolios including Dynamic Equity Income.

Innergex, with a market capitalization of $560 million, is a developer, owner and operator of hydroelectric facilities. Its management team, under the leadership of CEO Michel Letellier, is "experienced and focused and is making significant contract wins," Gibbs says, adding that hydroelectric power is "a valuable asset. The power is renewable and green." The yield on this stock is 6.1%.

A pipeline trust that Gibbs considers also offers good long-term potential is Inter Pipeline Fund IPL.UN, which is held in a number of the team's equity-income portfolios. This trust, with a market capitalization of $3.5 billion, "owns important energy-infrastructure assets in western Canada," says Gibbs. The trust has announced that it will be able to maintain its current level of cash distributions to unitholders in 2011 and beyond, despite becoming a taxable entity in 2011. It has a distribution yield of 6.6%.

Turning to energy producers, the largest holding in Dynamic Equity Income is Vermilion Energy Inc. VET, which has a market capitalization of $3.1 billion. Vermilion has operations in Canada, Western Europe and Australia.

The company converted to a corporation from an oil and gas royalty trust, Vermilion Energy Trust, at the beginning of September, says Gibbs. "It will maintain its distribution as a dividend." The dividend yield on this stock is 5.9%.

An ongoing strategy of the team has been to reduce its exposure to the health-care industry. It recently sold its holding in Medical Facilities Corp. DR.UN which has controlling interests in four specialty surgical hospitals in the United States. "There is increasing risk of adverse U.S. government regulation of the industry," says Gibbs.

As reported in a mid-April Encounter column, Gibbs and the team sold their holding in CML HealthCare Income Fund CLC.UN, which provides medical imaging services in Canada and also operates in the U.S. Northeast.