Oy, Canada!

Income Investing

Oy, Canada!

A sudden tax proposal by Canada's finance minister just knocked 10% to 15% off the value of shares of most Canadian income trusts and threatens to leave them with less money to pay dividends. If you invest in these high-yield securities, should you k

Canadian trusts that pass along income from oil and gas or coal production have become popular with U.S. investors because of stout dividend yields and, in recent years, significant price appreciation. Annualized total returns of about 40% over the past three years have been common, as high coal prices and the increased long-term value of energy reserves have turned the trusts, many of which trade on the New York Stock Exchange, into growth stocks as well as income plays. And with the Canadian dollar stronger against the greenback, the dividends have become more valuable.

But a surprise Halloween proposal by Canada's new government to tax trusts more like corporations -- in effect, reducing the money available for dividends -- threatens to upend the Juggernaut. The Canadian stock market dropped almost 3% on November 1 in reaction to the tax plan, although it still must win approval by Canada's Parliament, and, as written, wouldn't affect existing income trusts for four years. It was certainly a bad day but not a reason to fret about the Canadian stock market or the economy. Both are in good shape.

However, the north-of-the-border income trusts do bear a re-examination. The tax plan isn't just a money-grab by the government, but a response to a real problem. So many Canadian businesses, not just energy producers, have organized or restructured as trusts to save on taxes and attract yield-happy investors that the Canadian treasury says it is losing needed revenue. The trend also threatens Canada's economic growth. Once a corporation becomes an income trust, it must pass the bulk of its profits to the shareholders. This cuts taxes but leaves little in reserve for business expansion, research and development, or acquisitions. Imagine if corporate America handed over all its profits to shareholders and left itself with nothing to reinvest for growth. The economy would have a stroke. Canada doesn't want to serve as a laboratory for such a possibility.

News coverage in Canada assumes that the tax plan will fly, although the investment industry may fight it because investors, from pension funds to pensioners, are furious. "The uproar is unbelievable," says Rob Carrick, personal finance columnist for The Globe and Mail, Canada's largest newspaper. It's clear, though, that Canadian politicians aren't big fans of income trusts. Carrick says that the governing Conservative Party will need allies to enact the tax plan, but notes that the rival Liberal Party tried something similar a year ago, when it was still in power, but didn't follow through (income-trust prices fell then, too, but recovered).


So, let's assume that the proposal is a done deal. What's the practical implication for income investors in such prominent stocks as Enerplus (symbol ERF), PrimeWest Energy Trust (PWI), Provident Energy Trust (PVE) and Fording Canadian Coal (FDG)?

First, don't assume that this is one of those instances of panicky traders doing the wrong thing by selling first and asking questions later. The trusts are unlikely to make a full recovery any time soon. For that to happen, the government would have to drop the tax plan, or the Canadian parliament would have to kill it. It doesn't help that coal and natural gas stocks have been weakening lately on both sides of the border because energy prices have been retreating.

Second, it's no accident that the U.S. trusts weren't affected. In fact, they may even benefit. Such American standbys as San Juan Basin (SJT), Cross Timbers (CRT) and Sabine Royalty Trust (SBR) can play the same role in your portfolio, passing along income mostly from gas production and giving you some growth potential if energy prices rise. Yields today on U.S. royalty trusts hover around 7% to 8%. That's less than what the Canadian trusts yielded even before their price drops, but nobody on this side of the border is threatening to end the tax advantage of royalty trusts. So if you're looking for a yield-oriented energy investment, favor U.S. royalty trusts.

Third, because of the November 1 collapse, some Canadian trusts now look extremely tempting as high-yield plays. Fording Coal, the world's second-largest exporter of metallurgical (steelmaking) coal, distributed $4.80 Canadian over the previous four quarters. Its most recent dividend was 80 cents, so, to be conservative, assume an annual dividend rate of $3.20. That's $2.80 in U.S. dollars on a stock that after a long decline closed at $21.07 November 2. That's a yield of 13%. (You lose some income up front to a Canadian withholding tax, but you can recover it by filing for a foreign tax credit from the IRS.) You'd have to buy a bond of a company in or near bankruptcy to earn a yield that high. So if you're an aggressive investor looking for an ultra-high yield, you might consider making a small investment in Fording (FDG). The stock dropped $1.28 on November 2, bringing its two-day loss to 17%.


In the long run, though, Fording's performance will depend on what happens to coal prices. Meantime, the favorable Canadian tax treatment that allows the high dividends (which qualify for the 15% income tax rate in the U.S., by the way) will last another four years at least. "The stock will cruise for a while, but I think there will be some opportunities opening up," says Carrick. Demand for energy isn't going away, and there's still a case for investing in energy stocks. It's a matter of finding the right price, which, given the uncertainty of the tax situation, may be trickier than normal in this case.