INCOME TRUST INVESTMENTS

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TrustInvestor and the iTrustReport is designed to be an investors' Guide to Canadian income trusts (see below for issues included in our Guide), but also our News Digest, iTrustIndex, Ratings, income investor forum & resources.

Our information compliments other news and equity quotation services and augments other research sources because we are independent and focus on fundamental qualities of the business underlying an income trust.

At the heart of our information is an iTrustIndex, an investor-friendly equal-weight index for the full universe of income units. It is an objective way to track and compare the performance of all income units and sectors within the market by assuming an investor purchased $1000 of every income-oriented issue on the first day of its trade in the market. It also focuses on total returns in terms of annualized rates of return on unit price appreciation plus annual rates of income from distributions.

What is an income trust?

An income trust is a financial product that involves a security listed on the stock market and relates it to an actual business. Units are issued by non-incorporated organizations to serve as an asset-backed equity, like a share or unit of ownership. The unit issuer promises to pay unit holders cash flow generated from a business or set of investments through regular cash distributions.

Formed with a legal contract between the company and unit holders, a trust indenture, defines unit holder rights and expectations in a way not seen with traditional equities. That document along with a new issue prospectus defines how companies that establish a trust can receive capital from investors and how the company will use that capital. It also helps define company plans to pay returns to investors, paying cash back to them over time. Those returns are paid through regular cash distributions, quarterly or more often on a monthly basis.

Income trusts use a legal form used through time by mutual funds to describe how returns will be paid to owners who are the beneficiaries of the fund. In fact some structured funds or financial managers of funds of funds, promote their diversified products as if basic income trusts. We refer to them as structured funds, noting that they carry an added layer of management with fees on assets held, not typical of business-specific trusts.

Distributions can be associated with a percentage of the revenue generated by a company, usually driven by cash-producing assets:

- Royalty income tied to top-line revenue, earnings or bottom-line returns;
- Traditional business net income from operations or rental of property;
- Net cash flow from actual business operations after company reinvestment; or
- Cash flow from all business activities including new financial issues;
- Interest income from debt issued by the business or an operating division;
- Income from an investment portfolio held in a structured fund.

The ratio of distributions to the basis for their payment (such as cash flow) is described as a Payout Ratio. Healthy relationships between trust unit holders -- recipients of returns -- and underlying companies that produce returns would be seen as possible, therefore, in companies that have a payout ratio of 100% or less. Trusts, like companies need to retain some cash to maintain their own operations or to be able to reinvest in growth without issuing new units or debt.

Depending on the way returns are paid out from the business, it often avoids paying corporate tax because it pays returns to trust unit holders who are fully responsible to pay tax. Individual trust unit owners pay tax on those returns.

Income trusts have traditionally been based, therefore, on businesses that are stable, mature and so provide a predictable cash flow sufficient that distributions can be made, rather than reinvestment. With income in the hand of unit holders, it is the unit holder that determines how cash is spent including where reinvestment is made. Many trusts, however, have been planned to include sufficient cash flow to make both distributions and capital expenditures.

Generally, the cash distribution rate for trusts exceeds typical dividend rates for equities as well, in the last five years, interest rates on bonds or other fixed income investments. Given the way trust units are priced by sellers and buyers in the market and given a dollar amount of cash distribution, the resulting yield on a unit in the market is based on price. That yield shows a premium when investors discount the price of a unit due to its risk for owners. Those risks include everything from specific business risk, through market and currency risks all the way to overall economic risks.

Neither equities or bonds, trusts are distinct from and somewhat like both -- for better or worse. Like an equity, there is NEVER a guaranteed return on investment from an income trust. The fundamental quality of the underlying business, in its market, matters.

In fact, we include -- as is common in the equity market to do -- in our definition of income trusts, a range of legal entities that flow-through cash returns to unit holders. These include Limited Partnerships and Income Deposit Securities that work in a somewhat similar fashion as income trusts. Investors need to understand, however, that these forms of legal contract may not make provisions for there to be trustees to manage on behalf of the interests of investors.

Investors would best know their voting rights and legal representatives in management of the security that they purchase, regardless of the nature of its structure as an income unit, traditional equity or otherwise. Know who you're trusting with your money and what you're buying by putting your capital towards someone else's risky venture.

Why Trusts Are Attractive to Investors

Flow-through securities like income trusts establish explicit legal contracts that can focus managers, like investors, on profitable operations and tangible net returns. Managers should be able to improve per unit business results through effective management and organic growth. New issues of units to raise capital must be justified by managers working with specific investment goals and expectations of returns.

Trust units pay regular cash as distributions and trade in the stock market like a common equity, share or unit of ownership. Investors can participate easily in the market through direct investment at a relatively low transaction cost.

The cash distribution rate can exceed typical dividend rates for equities. Units may be priced to reward risk capital as well, so that the distribution rate relative to unit price "yields" cash at a rate higher than interest from bond or other fixed income investments.

Regular cash receipts from unit ownership dampens tendency for most investors to trade units based on price alone. And, with cash-in-hand, unit risk is low compared to many traditional equities. Commitment to frequent cash returns also ensures managers are focused on profitability, cash management and maintenance of their good relationship with investors more than investors might expect from traditional equities.

Trusts are often described as "tax efficient" for investors. That is because the trust does not pay corporate tax like a corporation. And taxes paid by investors can provide them greater relatively flexibility in timing of taxation compared to corporate tax. When units are held within a registered retirement savings account in Canada, for example, tax on cash returns and on capital gains are paid as if fully taxable income, but not until cash is taken from the account by its end beneficiary. That means that taxes are paid, but can be deferred.

Income units are taxed in the hands of investors rather than corporations. And so trusts are frequently described as if taking advantage of a tax loophole and avoiding tax. But trusts pay capital gains related taxes at the point they convert their corporate structure to or add to it the unincorporated income trust unit issue.

If held outside a retirement savings account, investors who pay the taxes on trust income will have to do some work to account for the different kinds of returns being paid to them. Some of the cash distributions might be interest-like income while some of it can be in the form of a dividend (each with its own tax rate). But so too, portions of the distribution can be treated as a Return of Capital (ROC) so that taxes on it are deferred until the unit is sold. The deferral reduces the unit holder's adjusted cost base and the amount of capital gains he or she pays when selling the units in a traditional (non-registered) investment account.

Investors should be clear about the source of that ROC. It can be a return of capital to account for specific tax credits that the underlying company has had during the set up of the trust, for example legitimate government investment tax credits provided to oil or gas producers. ROC can also reflect payments to return money to investors when there is a sale of assets that unit holders effectively purchased for the company when money was invested in its trust issue.

With traditional trusts, it is seldom the case. But investors should also look closely to ensure that a company is not simply issuing new units on a repeated basis, without investing new capital in productive assets, but rather returning investors money as a return of capital to unit holders.

Good quality companies have formed trusts to obtain investor's capital for investment in productive assets that generate earnings including cash flow that can be reinvested to build more productive assets and to grow.

This means that some trust issues offer unit holders potential for both cash income and unit price appreciation: Yield & capital gains for unit holders.

In or outside retirement accounts, income trusts provide a promise to pay investors returns from a business and base of assets. Frequent payments give unit owners discretion over how money is spent for their own purposes like daily living or how the cash may be reinvested with a new view of market and business risk for future returns.

How do I protect myself from risks?

Consider income trusts to be the same as equities, but expect to be paid cash returns. The means:

- Understand what you're buying. The simpler the offering the better;
- Consider all risks outlined in the company prospectus;
- Due diligence and research on fundamental business risk is essential;
- Focus on fundamental measures of business, market and economic potential;
- Avoid totally new public offerings until you can see a history of business performance;
- Avoid known public companies that float trusts just to issue new units.
- Look at who is selling units and why, including insider holdings and sell-outs;
- Avoid all issues with a payout ratio of 100% or more (this will include new issues);
- Do not buy just to obtain very high rates of yield. Those units are priced for high risk;
- Buy units with more than a year of good annualized rates of total returns:
  including annualized price gains along with annual rates of distribution;
- Ensure price gains are supported by fundamental net earnings or asset growth;
- Know that total returns are less on funds of funds than trusts;
- Understand that price volatility is higher on funds of funds than business-specific trusts:
- Like all equities, diversify holdings across economic and business sectors;
- Like common stock, know that income trusts never guarantee returns.

Use our iTrustRatings and Report or the related background and methodology screen for value.

If you work with an advisor or broker expect that they are paid a commission to sell you new issues. In any and all cases, do not allow your advisor or broker to trade on your account unless you are totally sure that they can answer all of your interests, concerns and questions. No question is too dumb.

Whether you're buying bonds, equities, income trusts or funds of funds, your financial service provider should be able to explain why a purchase or sale makes sense in the context of your individual requirements and for the specific security in the context of the overall market

Specific Issues Covered By TrustInvestor & the iTrustReport

INCOME TRUSTS

Units of a specific business formed as or converted into a legal trust structure that provides regular distributions to unit holders. These include:

Units denominated in Canadian dollars and that trade on the Toronto Stock Exchange, representing ownership in the income from:
- Oil and gas producers;
- Pipeline, energy related facilities and services;
- Power generation;
- Real Estate Income Trusts (REIT's) operating residential
  or commercial accommodation properties;
- REIT's offering hotel and other temporary lodging;
- Food related operations;
- Other forms of business

Open-end trusts for which new units may be issued over time and, in some cases, closed-end trusts that have a defined number of units issued. They may also include certain limited partnerships (LP) and equity units structured to pass cash flow and its tax implications through to individual owners.

Units in businesses that either make an "initial public offering" (IPO) of units in a legal trust or convert equity structures and limited liability organizations into trust units.

STRUCTURED FUNDS

Structured funds are established with diverse holdings by fund managers to provide regular distributions to unit holders. They may also be called "income trusts" or "structured trusts". But they are diversified funds. People consider them funds of funds. These include:

Units structured to pay distributions by holding a variety of investment products, sometimes specialized in one or more areas, including portfolios of trust units, equities or preferred shares and, in some cases, bonds in Canadian or other markets.

Units denominated in Canadian dollars and that trade on the Toronto Stock Exchange.

Closed-end trusts that have a defined number of units issued and, in certain cases, limited partnerships (LP) or equity units structured to pass cash flow and its tax implications through to individual owners.

Units structured much like mutual funds that trade in a public market and have similar expense structures including fees and expenses based on a percentage of assets managed by financial managers. Some closed-end units have redemption features and a termination date.

Trust units sometimes called "specialty products" because they use sophisticated financial or investment techniques (such as forward and unique debt structures) in an attempt to stabilize returns and minimize risks, often incurring large management fees in the process.

EXCLUSIONS

Units or shares denominated in $US.

Traditional equity shares and preferred shares that pay dividends.

Exchange traded index funds (ETF's) despite the fact that these units can be similar to Structured Funds (above), because ETF's are often created to serve more as an index for capital markets than a reflection of income-oriented products.

Split shares, for specific businesses, created when a holding company or trust is formed to issue, in turn, two separate shares to concentrate the capital gains and distributions in "split" shares representing holdings in the underlying business.

Tax shelter units in closed-end trusts that own a share of revenue from partnerships established to run mutual funds. These units pay distributions that appear to increase as a yield on unit value because units depreciate over time. They have no final redemption value but provided initial investors with a tax shelter

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