I often receive e-mails from readers wondering about the suitability of income trusts for DRIPping. With the prospect of rising interest rates comes the threat of falling unit prices. No one can say how high interest rates will rise or for how long. However, as I write this article the market is already taking this unknown into account.
DRIPs have historically been suited to small and cautious investors. Trust DRIPs would seem just as suited for investors who like to income average contributions. Simplistically, as interest rates go up the unit prices of trusts begin to fall as people turn to the greater security bonds provide. As unit prices of trusts fall their yield increases. Realistically, it’s never as simple as that. For example, if a trust has considerable debt the increased cost to service the debt will reduce the profit available to distribute to unit holders. This, in turn, will depress the yield. Still, it would seem good trusts with dividend reinvestment plans can be an effective way to play uncertainty.
Intuitively, it would seem that if a trust historically returns 3% more than bonds then income averaging over time would provide a return 3% above the average interest rate. At the same time unit prices paid are also continuously being averaged as well. The risk to invested capital is averaged then.
The number of Canadian trusts offering DRIPs with unit purchase plans currently out number Canadian companies offering DRIPs with stock purchase plans. To explain the popularity of DRIPs with these companies let’s start with a brief explanation of trust structure. (For simplicity for the remainder of this article SPP will refer to either a stock or unit purchase plan.)
When a trust is established it can purchase shares (common and preferred) and debt securities in a company to the benefit of unit holders. In a sense, when a company converts to a trust structure it is buying itself.' Held within a trust structure, the operators of the trust, called trustees, can now pass certain benefits, such as company profits, directly to the unit holders. In effect, the unit holders are now subject to some of the taxation previously paid by the company.
An advantage to the unit holder is that tax advantages/consequences previously claimed by the company now flow through to the unit holder. People are well aware that income trusts must pay out a large portion of earnings to unit holders. Often misunderstood is the “Return of Capital”. Some people, confused by the term think this means a portion of their original investment is being returned to them. Further, they assume for example if their trust is delivering a 10 percent return but is 50 percent Return of Capital then the true return is only 5 percent.
Actually, if one invests $1000 in a trust the investment is still $1000 regardless of the Return of Capital. Return of Capital is actually a tax consequence flowing through to unit holders. Such a tax consequence can arise from the natural depreciation on assets claimed by the company now passed to the unit holder. If one looks at the financial statements of some trusts it seems more is being paid out than was earned. Tax consequences from claiming depreciation can be a contributing factor for this.
Beyond that, at their very basic level, trusts were designed to be “wound up”. That is, the assets of the company will be used up. This makes more obvious sense when looking at Oil & Gas trusts. Oil & Gas trusts are based on a depleting asset. As the oil is taken out of the ground the earnings are passed on to the unit holders. Oil & Gas trusts have stated reserve lifetimes. Once the reserves are depleted there are no further earnings to encourage future investors.
This partially explains why DRIPs seem very popular in the Oil & Gas trust sector. Oil & Gas trusts need to replenish or purchase more reserves to continue operating. However, as trusts are required to pay out the majority of earnings to unit holders, this is a very limited source of funds for acquiring properties.' Providing a DRIP with a stock purchase plan can be a fairly predictable source of income for trusts to direct towards replenishment or growth.
Yes, “growth”. The newspapers abound with references to companies converting to a trust structure because they have low growth prospects and predictable earnings. But “low growth” does not mean “no growth”. Hot House Growers Income Fund (TSX: VEG.UN) one of the largest producers of premium quality greenhouse tomatoes and sweet bell peppers in North America recently received fast track approval for a $27 million plant expansion.
Generally income trusts can be categorized into four subgroups:
Real Estate Investment Trusts
In this article we are going to look first at DRIPs and the business trust sector.
Unfortunately, the news for DRIPpers is in the business trust sector is not good. The business trust sector seems to be the low growth steady income area the newspapers refer to.' Typical is the response I received from the Superior Plus Income Fund (TSX: SPF.UN) a supplier of propane, related products, services, chemicals and technology to the pulp and paper and water treatment industries.Thank you for your interest in the
Robert Gibb, 401-2910 Cook Street, Victoria, BC, V8T 3S7 (250) 383-7075 [email protected]. Robert Gibb is a retired school teacher. He gives seminars on dividend reinvestment plans. Mr. Gibb is a frequent contributor to Internet DRIP boards under the nickname OperaBob.