Alternatives to the trusts

You've lost your trust in income trusts. So what's next?

Dividend growth stocks are a good option if you have a long investing horizon. High-yield bonds are worth a look, too. And, if the current volatility in the trust market hasn't totally put you off these securities, then you might consider a mix of income-generating mutual funds.

Uncertainty rules in the trust world right now. Federal Finance Minister Ralph Goodale has said he will announce the government's new policy on trusts early in the new year, but this timetable could be disrupted by a winter election. At best, investors have months to go before they learn if Ottawa will address its concerns about trusts by taxing them or by finding less painful measures.

If your response to this is to opt out of trusts, then you'll have to look elsewhere for the rich streams of income that trusts pay through their monthly cash distributions. Prepare for a lot of compromising.

"There really isn't anything else that is going to offer the same level of cash flow as income trusts," said Dan Hallett, a Windsor, Ont.-based independent provider of investment research. "That's the challenge."

Tony De Thomasis, an investment adviser in Thornhill, Ont., has refused to put his clients in income trust mutual funds for a while now, so he knows the challenges of finding alternative investments. "You have to lower your expectations for income," he said.

With that in mind, let's look at three alternatives to owning trusts directly or through funds:

1) Dividend growth stocks

Theoretically, what you're doing here is replacing a trust yielding something like 8 per cent with a dividend stock yielding a ballpark 2.5 per cent. Does this make any sense? Yes, if you can live for a few years with a reduced income flow and you make sure to buy a stock that regularly increases its dividend payments.

Rising dividends mean the yield on your initial investment will grow steadily over the years, and that means more income each quarter when dividends are paid. An ideal example is Power Financial Corp., said Kevin Dehod, vice-president at McLean & Partners in Calgary.

Mr. Dehod said Power paid a 42-cent dividend five years ago that yielded about 2.5 per cent, based on a share price of $16.35. The dividend has grown to 87 cents a share today, which means the yield on your investment is up to 5.3 per cent. "Dividend growth is not for maximizing your current income in the next three or four months, it's a long-term process," he said.

The Power Financial example shows two other benefits of investing for income through dividend-growth stocks. First, rising dividends tend to support a rising share price, which you can see in the fact that Power Financial today trades around $32.50.

Second, the dividend tax credit means dividend income from Canadian companies is taxed less heavily than trusts with distributions that are mainly or completely income. (Some trust distributions may be treated as capital gains.) Mr. Dehod said the 5.3-per-cent yield on Power shares bought five years ago is equivalent to a guaranteed investment certificate paying 6.2 per cent when taxes are considered.

Mr. Dehod focuses on dividend-growth stocks that have raised their payouts in at least eight of the past 10 years, with an average annual increase of 8 per cent. He noted that most trusts don't increase their distributions on a regular basis, and the size of any increases is often small.

2) High-yield bonds

Here, you're investing in the bonds of firms that lack the top credit ratings of governments and blue-chip companies and thus offer investors higher interest rates. Examples of high-yield bond issuers include Bombardier Inc., Shaw Communications Inc., General Motors Acceptance Corp. of Canada Ltd., Ford Credit and Fairfax Financial Holdings Ltd.

A couple of these names might provoke some concern from conservative investors about risk. But consider this: Bondholders have a better chance of getting paid by a company in trouble than trust unitholders have of getting paid distributions by a troubled trust.

"If you look at an income trust that issues bonds also, the trust unitholders are going to lose out on distributions before the bondholders lose out on interest," said Mr. Hallett, president of Dan Hallett & Associates. Mr. Hallett said he's suggested investors have about 10 per cent of their portfolios in income trusts, and he thinks the same percentage could apply to high-yield bonds if they were used as a substitute for trusts. "If you could justify a certain percentage in trusts, I think you can certainly justify the same percentage in high-yield bonds."

Because the credit quality is lower, buying individual high-yield bonds is trickier than buying government or blue-chip corporate bonds. For that reason, most trust investors would probably feel most comfortable using a high-yield bond fund. Most of these funds allow unitholders to receive income monthly (or have it reinvested), and the yield is now in the 5- to 6-per-cent range or a bit higher. Note: The amount of cash actually paid out each month varies, whereas most trusts make level payouts.

Interest paid from high-yield bonds and bond funds is treated as straight income by the Canada Revenue Agency, which means you could end up paying more tax than you did on trust distributions. A portion of some, but not all, trusts is taxable as capital gains.

3) A mix of income-generating funds

Mr. De Thomasis has avoided income trust mutual funds for clients of his firm, DeThomas Financial Corp., but he says they can be used sparingly as part of a diversified package of mutual funds that pay regular income.

The big banks and lots of other fund families offer monthly income funds that do this in one neatly wrapped package, but Mr. De Thomasis says it's better to build your own fund because you can evenly spread your money between different kinds of assets. His problem with monthly income funds is that you could end up being hurt if the manager wrongly emphasizes one asset in a belief it will outperform the others.

Here's the mix: Take 80 per cent of the money you would otherwise have invested in trusts and divide it equally into a dividend fund, a real-return bond fund, a global real estate fund and an income trust fund. Keep the remaining 20 per cent in cash and pay it out quarterly into whichever of the four funds is doing the worst. "Something is going to hiccup," Mr. De Thomasis said. "This way, you have a good opportunity to buy more."

Aside from diversification, he added, this mix of funds also offers inflation protection. If prices rise a lot, then the real estate and real-return bond (it holds bonds paying a premium above the inflation rate) should do well. If inflation proves not to be a threat, then the dividend and high-yield bond funds should do fine.

A caveat is that investors who need to maximize their monthly income may find this mix of funds doesn't generate sufficient cash flow.

The compensation is the potential for tax-friendly capital gains.