Income Investing ABCs
Why Does Income Investing Matter ?
Millions of Canadians currently depend on the income from their savings to pay the bills. Whether they are retired, injured or disabled, this income replaces the employment income they once had. Its what they live on day to day and month to month.
Many millions more Canadians are on the cusp of retirement - including the baby-boomers - and will need viable income investments when they retire to pay their expenses. See our webpage titled “A Demographic Wave” to learn more about the "wave" of coming retirees.
Statistics show 66% of the Canadian labour force has no employer pension plan. Those Canadians have to personally save for their own retirement. They need to build up enough savings so that they can generate a retirement income from those savings. The amount of their savings and the rate of return they earn on those savings essentially determine how much income they have.
The net result is that a large and growing percentage of the Canadian population depends on the income earned on their savings for their economic well-being. Given this new reality, access to viable income investment returns is vitally important to the economic and social well-being of millions of Canadians.
What is it ?
Its investing your savings in types of investments that provide recurring, periodic payments to you. Like a term deposit that pays you interest twice a year. Or an income trust that pays you a cash distribution each month.
With income investments you hold the investment and receive payments from the issuer of the investment. You do not have to sell the investment to get money, although you may choose to sell or redeem it if you want. But if you do sell or redeem, the recurring payments are no longer made to you.
Types of Income Investments
Here are some examples of income investments and their typical current annual payout yields.
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Name
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Typical Current Yields
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Annual Payments on $300,000 Invested
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Dividend paying stock
GICs, term deposits
Government bonds
Preferred shares
Income trusts and funds
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½ - 4%
2 - 4%
3 - 4%
5 - 6%
8 -12%
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$ 1,500 – $12,000
$ 6,000 – $12,000
$9,000 – $12,000
$15,000 – $18,000
$24,000 – $36,000
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Income versus "Capital Gains" Investing
Income investing is different from buying an investment that you hope to get a return on by a “capital gain”. That is buying something at a price, hoping the price will go up, and selling later at the higher price for a “profit”. This is the situation with most common stock traded on a stock exchange. Capital gain type investments also carry significant risk that the price may go down and you will sell for a "capital loss". Most common stocks pay no dividends, or if they do, it’s at a much lower rate than other income investments. Also their trading values can vary quite dramatically with the ups and downs of the stock market. If a person holds stock in a falling market and needs money, they must sell some of the stock at a loss. This then further reduces the value of their savings.
Most income investors need recurring income because they need money to pay the recurring bills. Some income investors do not have the "temperament" or "risk tolerance" for holding investments that mostly provide capital gains / capital losses. They typically can't stomach the periods when prices in the stock market are falling (the value of their savings dropping) and knowing those investments are not making any recurring payments to them to provide money to pay their living expenses.
What Are Income Trusts and Funds ? - A Primer
Because there is considerable misunderstanding about what income trusts are, we thought it would be helpful to review the basics:
· Businesses can be structured and carrying on in different ways, for example as corporations, partnerships, proprietorships, joint-ventures or trusts. Income trusts are simply businesses carried on using a trust structure.
· Buying "units" of an income trust gives you part ownership in the underlying business.
· Trusts typically pay out a significant portion of their net cash flow to their unitholders, typically as a monthly "cash distributions". This is different than most corporations which do not make recurring dividend payments to their shareholders. Those corporations that do pay dividends typically pay a much smaller percentage.
· The price of the trust units may go up or down depending on how well the business does. If business and profitability increases, the price and monthly cash distributions typically over time go up. If business and profitability decreases, the price and monthly cash distributions typically over time go down.
· If an income trust retains its taxable income, it pays tax on that income at the highest individual rate (approx. 46%). And because nothing was distributed to the unitholders, the unitholders pay no tax. If the trust instead pays out all of its taxable income to its unitholders, the unitholders will pay tax on the income distributed to them. And the trust will not pay tax on the income distributed to its unitholders. This avoids double taxation of the same income.
· There are about 250 businesses listed as income trusts on the Toronto Stock Exchange covering most sectors of Canadian business and representing about 10% of the market’s total capitalization.
· Many "income funds", separate funds that hold a diversified portfolio of many, many income trusts, also trade on the Toronto Stock Exchange. They too make monthly cash distributions to their unitholders from the cash they receive from the income trusts in their fund portfolio. These vehicles enable smaller investor to gain a high level of diversification and reduce the risk associated with failure of, or difficulties at, any single business.
· Like all investment decisions, you should consult your investment professional to determine what makes sense for you based on your individual needs and circumstances. Income trusts have been around for many years now and most investment advisors are very knowledgeable about them.
Why Are Income Trusts Important ?
Because they allow seniors and retirees to access equity level returns in a way that works for them.
As noted above, income trusts are simply a business structure. But when a business is set up with this structure, it makes holding equity (the trust’s “units”) much more suitable* for seniors. By paying monthly cash distributions, income trusts meet seniors’ income needs. Unlike common shares, the historic form of equity ownership, there is no betting on “capital gains” to generate funds to pay the bills. Seniors can simply hang on to their trust units, as traded values rise and fall in changing markets, knowing the monthly cash distributions will allow them to meet their expenses. This is vitally important because it allows seniors to access much higher “equity” returns (8-12%) in a period where returns on debt instruments are very low (2-4%). It is accessing these higher "equity" returns that will help reduce the hardship millions of Canadians face (as detailed elsewhere on this website).
Income trusts have also played an important role in Canada’s overall economic development and prosperity of late. The income trust structure has enabled many smaller and medium-sized Canadian businesses to access the public capital markets to grow and expand at a much faster rate. Previously, many smaller and medium-sized corporations that listed their “common shares” on a Canadian exchange found less demand, less investor attention, and lower valuations. There has been a history in Canada of lower stock market valuations than those of key competitors, like the US. (This has been documented in a 2003 study by the Bank of Canada.) This puts Canadian business at a strategic disadvantage, as its easier for foreigners to buy our businesses with their more highly valued stock.
Indeed, the higher values and stronger ability to raise new capital associated with income trusts has allowed Canadian oil & gas royalty trusts to buy back over $10 billion worth of Canadian oil and gas reserves from US and other foreign owners. In a world of finite energy supplies, having ownership and control of our energy resources is strategically important.
After the Conservative government’s October 31st, 2006 announcement on income trusts, trust market values fell sharply. We have recently seen 12 Canadian trusts bought up by foreign “private equity” investors and this trend is expected to accelerate once the measures are passed into law. These foreign private equity buyers typically use high leverage (ie. a lot of borrowed money), which creates large interest expense deductions and essentiallly no income tax payable in Canada. Canadians lose ownership, public investment opportunities and tax revenue: a lose / lose / lose situation.
* The proportion of income trust holdings suitable for any particular investor should be determined in consultation with an investment professional that is familiar with the investor's particular circumstances.
