Generous dividends are the catalysts that draw most investors to Canadian income trusts. And as those who’ve owned trusts a while know that current income is only part of the story. Over time, share prices follow the dividend stream, so a rising payout creates capital growth as well.

The “Tax Fairness Act” created uncertainty about trusts’ future dividend streams and, thereby, a third way to play trusts’ dividend power: The potential for a big bounce in share prices as the best prove they can pay big dividends even if they are taxed as corporations.

Last month, Bonterra Energy Income Trust (TSX: BNE-U, OTC: BNEUF) became the first to announce early conversion to a corporate structure while maintaining its current dividend. The market’s favorable reaction is certain to encourage more trusts to follow its example.

That adds up to a triple play for investors in high-quality Canadian trusts now. First, you get the highest dividends in the world, paid monthly. Second, you get capital appreciation as good businesses grow and boost their distribution streams. Finally, as we approach 2011 and more trusts settle on a high-dividend-paying strategy, you’ll get a share price boost as uncertainty about future dividend streams is lifted.

All this, of course, is only possible if trusts have the businesses to sustain and expand their sales and earnings. That’s why we focus like a laser beam on quarterly profit reports. They may not have every piece of information we want, and they can’t foretell future economic conditions. But they are the best possible clue to how businesses are performing and, therefore, dividend paying power.

For the past two years, Canadian income trusts’ earnings have been stress tested successively by a series of unfortunate events. The first was a prolonged drop in natural gas prices beginning in mid 2006, which ground drilling activity in much of Canada to a halt. Then Hurricane Flaherty announced his “Tax Fairness Act,” proclaiming trusts would basically be taxed like corporations beginning in 2011 and limiting the amount of share capital they could issue.

By the middle of 2007, trusts with operations in the US and/or that exported to the US were being hit by the surging Canadian dollar, which simultaneously depressed US dollar revenue and made Canadian products less competitive. Finally, the credit crunch emerged in the US, drying up market activity and making it more difficult to borrow, along with the slowdown in US economic growth.

The bottom line: Canadian trusts and corporations across all industries have been forced to rely on their own resources—i.e., with limited access to capital markets—at the same time business conditions have crimped sales growth. Many have also faced rising raw material and energy costs that have further crimped margins.

The good news is virtually all Canadian Edge Portfolio recommendations have measured up to these stress tests to date. The proof is in strong second quarter earnings, which followed on the heels of solid results in the first quarter as well as the third and fourth quarters of 2007.

Our picks haven’t been immune from the North American bear market, which began in mid-2007. But their businesses have stood up to the stress tests that have challenged them for the better part of two years.

It’s still possible some will falter in the coming months, particularly if the North American economy does weaken significantly. The summer’s violent action notwithstanding, it’s still unlikely that oil will retreat and remain significantly below USD70 a barrel, or that natural gas will move well under USD6. But were that to happen, it could seriously challenge oil and gas producer trusts’ current level of distributions.

Trusts doing significant business in the US—including High Yield of the Month pair AG Growth Fund (TSX: AFN-U, OTC: AGGRF) and Energy Savings Income Fund (TSX: SIF-U, OTC: ESIUF)—as yet are still thriving. And the recent rally in the US dollar versus the Canadian loonie is certainly good news for their future earnings. But their challenges would steepen if the US economy were to completely collapse.

As long as this bear market and the stress tests behind it last, it will continue to be critical to scour earnings reports for signs of weakness. The next batch is due out in late October and early November. And I’ll be tracking them in the November issue as well as in subsequent Flash Alerts.

The point, however, is the great weakening still hasn’t happened yet, despite being well priced in by the market. The more strong quarters our favorites post, the less likely they will falter—and the more likely it is that they’ve either bottomed for this cycle, or are pretty close to it.

The upshot: If you’re light on trusts that have measured up to the stress tests thus far, this is a good time to pick up shares. If you’re already fully invested, hang in there and continue to collect distributions.

Including the impact of a 7 percent drop in the Canadian loonie versus the US greenback, 23 CE Portfolio picks are up for 2008. The average total return is roughly 18.5 percent. Nine are under water, with an average loss of 22 percent.

The average return for all CE picks—including the three closed-end mutual funds—is about 13 percent, or roughly 6 percent including the depreciation of the Canadian dollar. That’s a decent performance for stress-tested times. But as the figures above show, performance definitely hasn’t been even. And that’s not including the extreme volatility we’ve seen this year.

Bottom up analysis of companies—not market timing—is what we focus on at CE. US economic growth may revive this year with the medicine of Federal Reserve largesse and the recent dip (temporary in my view) in commodity prices and energy. Once it does, the stress tests will abate. Uneven Portfolio performance should quickly convert to upside.

Unfortunately, I certainly can’t rule out this challenging environment extending well into next year. And as long as it does, CE Portfolio performance is going to be uneven, just as it was in 2007 and has been this year.

All we can really do is focus on the business health of the Canadian trusts and corporations we own. As long as that’s intact, our picks will pay their huge dividends and recover any losses suffered to the market’s negative mood. In fact, their dividend power will put them in front of the market’s upward charge. Meanwhile, we’ll enjoy some of the best current income on the planet.

Unfortunately, not all trusts have measured up to the stress tests of the past two years. I’ve tracked the damage every month in the Dividend Watch List item in the Tips on Trusts section.

For the two years or so preceding Halloween 2006, it was extremely easy for trusts to issue share capital. Nearly one fourth of How They Rate trusts increased their outstanding share base at least 30 percent over the 12 months before Finance Minister Flaherty dropped his tax bomb. And new issues and initial public offerings were far more profligate outside CE coverage, as I had pointedly excluded unproven trusts.

Like Wall Street, Bay Street produces to investor demand. And in those heady days, demand was all about high yield. Canadian trusts’ ability to pass along heavy cash flow to investors made them immensely popular on both sides of the border. And investment houses both in New York and Toronto took full advantage, launching a flood of new trust offerings, even as existing trusts sold tranche after tranche of new shares.

In any environment where capital is cheap, there are considered offerings by strong businesses anxious to grow. There’s also a great deal of what really amounts to junk, a big yield slapped on a grab bag of assets and peddled to the less discriminating.

Not surprising, when the stress tests began to bite, this was the group from which most failures flowed. According to Scotia Capital, some 35 trusts have completely suspended distributions the past two years, and dozens more that are still paying have had to make painful cuts.

Complete meltdowns like those have been thankfully rare on the How They Rate list. In fact, only five listed trusts currently don’t pay distributions, and we’ve been fortunate to have steered investors away from all of them well in advance. We have, however, been caught recommending a few that failed to measure up to stress tests, including three this year in the CE Portfolio.

The first to get hit was Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF), which cut its distribution 22 percent in the face of weak first quarter results. The reduction took its share price down to its current range of around USD5, from which it basically hasn’t budged since.

The good news—as reported in the August CE High Yield of the Month section—is Boralex’ second quarter numbers showed considerable improvement. The weak hydro conditions of earlier in the year moderated, though output from the trust’s dams was still below last year’s levels. More important, the company posted strong results at its cogeneration unit and progress resolving the dispute over its biomass power plant Dolbeau.

The latter remains a challenge, especially since weak forestry industry conditions have reduced the supply of wood waste. But the second quarter numbers are a pretty good indication that Boralex’ lower distribution rate is sustainable enough for the trust to rate a buy for more aggressive investors up to USD6.

Last month, we saw two hold-rated CE Portfolio trusts trim payouts: Arctic Glacier Income Fund (TSX: AG-U, OTC: AGUNF) and GMP Capital Trust (TSX: GMP-U, OTC: GMCPF). Both are discussed at length in the Dividend Watch List section.

Both trusts’ share prices have taken substantial hits this summer. Arctic’s came immediately prior to and in the wake of its second quarter earnings announcement and subsequent dividend cut. GMP’s, in contrast, unfolded over the summer as weak transaction activity in Canada made clear that second quarter results would be weak. As a result, the shares have actually rallied slightly since the dividend cut.

Since this bear market began, my philosophy has been zero tolerance. That basically means selling any companies or trusts whose businesses obviously weaken in the face of the stress tests underlying the bear market.

Everything gets hit in a bear market. But it’s the investments that truly weaken fundamentally that really blow holes in portfolios. Negative market moods inevitably shift, and when they do high quality—what’s weathered the business stress tests—is the first thing buyers focus on. In contrast, money comes back to what’s cracked only very slowly, if at all.

A strict application of this rule would call for selling Boralex, Arctic and GMP. Instead, I’ve elected to sell only Arctic, which is also being challenged by an increasingly expensive US Dept of Justice (DoJ) investigation of its packaged ice business.

In contrast, GMP has no side issues. Its slide has been due solely to very negative market conditions. These may persist a while more. But the trust is still maintaining market share in its key operations, even as it expands new ventures and controls costs. As long as it’s doing that, GMP is a lock for dramatic recovery when conditions do improve.

Meanwhile, Boralex’ basic business of selling power is highly resistant to economic slowdowns. And its financial fortunes are closely tied to those of its parent and operator Boralex Inc (TSX: BLX), which remains very strong as indicated by solid second quarter results. All that really has to happen to maintain the dividend and recover lost ground in the market is for Boralex Inc to resolve the problem at the biomass facility, which appears to be happening.

In retrospect, it would have been better to sell GMP earlier this year at a higher share price, as it would have been to unload Arctic and Boralex. It may also be that GMP will wind up losing key personnel and market share, or that Boralex Inc will be unable to resolve the Income Fund’s issues and will be forced to cut the distribution further.

At this point, however, we don’t have that option of selling at a higher price, at least not until a recovery unfolds. And recovery looks a lot more likely for both, rather than further deterioration. I will be scrutinizing both trusts for signs of progress and/or backsliding, particularly when third quarter results are released.

Until then, however, both trusts are good buys for more aggressive investors who don’t already own them, GMP Capital Trust to USD14 and Boralex Power Income Fund to USD6. Note Arctic Glacier is a sell, per the August 14 Flash Alert. I’ll continue to monitor the business in How They Rate, and will consider adding it back when the DoJ investigation comes into better focus.

In the August issue, I reviewed second quarter earnings of the 14 trusts for which numbers were available. I highlighted the remainder in three Flash Alerts, dated Aug. 7, Aug. 14 and Aug. 20.

All three Flashes can be accessed on the Canadian Edge Web site from the “Archives” section. To see everything I’ve ever written on a particular trust, simply click on “Search” in the main menu on the left side of the homepage, and type in the name of the desired trust.

In the interest of avoiding repetition, I’ve kept the earnings write up brief for each trust below (those not covered in August). I’ve reviewed results of two holdings—AG Growth (TSX: AFN-U, OTC: AGGRF) and Energy Savings Income Fund (TSX: SIF-U, OTC: ESIUF)—in the High Yield of the Month section.

Note that two trusts reviewed in the August issue announced major strategic moves last month to boost future earnings. Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF) will build two new oil sands pipeline systems under long-term contract at a cost of CAD400 million, slated for service by mid-2011. Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF) has purchased Get It Pages, entering the Saskatchewan market with a bang. Buy Pembina Pipeline Income Fund up to USD18 and Yellow Pages Income Fund to USD14 if you haven’t already.

One of my three featured closed-end mutual funds, Select 50 S-1 Income Trust (TSX: SON-U, OTC: SFYIF), is again trading under its OTC symbol in the US. Management has issued its annual “Redemption Privilege” for units, under which unitholders can cash in at 100 percent of net asset value for a fee of CAD30 by the Sept. 12, 2008, deadline.

It’s always nice when a closed-end fund buys back shares, as the resulting arbitrage tends to close discounts between the market price and net asset value (NAV). These have become quite hefty over the past year for closed-end funds. In Select’s case, however, the discount is now only about 3 percent.

That’s too small a discount to make redemption worthwhile, especially considering the solid nature of this fund, its strong management and the low price of much of its current portfolio. My advice is to be thankful for the offering, which has narrowed Select’s discount to NAV sharply. But say “no thanks,” and hold your shares. Select 50 remains a buy up to USD13 for those who don’t already own it. Note the posted yield in How They Rate still includes the annual special dividend in addition to the regular monthly rate of 8 cents Canadian per share.

I also remain positive on my two other favored funds. EnerVest Diversified Income Fund (TSX: EIT-U, OTC: EVDVF) continues to trade at a whopping 17.3 percent discount to net asset value. In my view, that’s largely because management has refused to do the kind of buyback Select 50 has. Unfortunately, I have no timetable for when they might. But the fund continues to produce steady investment returns and the discount means the yield on market price is much higher than NAV, meaning it’s more sustainable than it looks. EnerVest Diversified Income Fund is still a buy up to USD6.50.

Finally, Series S-1 Income Fund (TSX: SRC-U, OTC: SRIUF) trades at a modest 6.7 discount to NAV and continues to chug along with solid investment returns. The small size and conservative diversification are also very attractive, with more cyclical oil and gas producer shares only a fifth of the portfolio versus nearly half in stable power generation, energy infrastructure and real estate investment trusts. The monthly payout is 7.5 cents Canadian per unit, and Series S-1 Income Fund is a buy up to USD10.

Advantage Energy Trust’s (TSX: AVN-U, NYSE: AAV) fortunes are closely tied to natural gas prices. So it was no great surprise that second quarter earnings surged on a combination of 13 percent higher output and higher realized prices for oil and gas. The second quarter average realized price of USD9.18 for natural gas is somewhat above current spot prices, but profits will be protected by the same hedging that held back earnings when gas was rising. Meanwhile, the trust has used its cash flow to reduce its debt burden and enhance future output, both of which will improve sustainability. Yielding more than 12 percent and selling for just 1.2 times book, Advantage Energy Trust remains a buy up to USD14.

Algonquin Power Income Fund (TSX: APF-U, OTC: AGQNF) came in with solid second quarter numbers, as its portfolio of US and Canada-based power plants and water treatment facilities ran well. The trust, for example, processed 60 percent more waste than a year ago. The weak US dollar was again a burden, but management maintained its distribution is sustainable, with a full-year payout ratio after maintenance capital expenditures projected at around 100 percent. That may make some uncomfortable, but the trust’s ability to do big deals such as the Highground Capital Corp purchase should assuage any cash flow concerns. Buy Algonquin Power Income Fund up to USD9.

Artis REIT (TSX: AX-U, OTC: ARESF) continued its record of rapid growth in the second quarter, and rewarded shareholders with a 2.9 percent distribution increase as well. The key is the robust health of Canada’s energy patch real estate, which resulted in higher occupancy and rents, and a 20.6 percent jump in distributable income per share. In my view, growth will eventually slow, but the REIT is already priced for it, yielding nearly 7 percent despite a low payout ratio of just 62.5 percent. Buy Artis REIT—which is much cheaper than US REITs of far lower quality—up to USD18.

Atlantic Power Income Fund (TSX: ATP-U, OTC: ATPWF) shocked investors who had swallowed rumors of weakness, posting a big jump in second quarter earnings as well as confirmation it was following though on plans to buy back up to 8 percent of its income participating securities. Relatively low float could still make this one a bit volatile. But its portfolio of power plants and power lines under very long-term sales contracts is solid. Atlantic Power Income Fund is a buy for those who don’t already own it up to USD12.

Canadian Apartment REIT’s (TSX: CAR-U, CDPYF) growth in western Canada continues to boost cash flow. Meanwhile, solid performance in more economically challenged eastern Canada will keep things steady when growth in the west does eventually slow. Last month’s purchase of an apartment property in British Columbia should begin adding to profits immediately. Buy Canadian Apartment REIT up to USD20.

Keyera Facilities Income Fund (TSX: KEY-U, OTC: KEYUF) lifted its dividend another 11 percent last month, hardly a surprise since distributable cash flow rose 80 percent from year earlier levels. All energy infrastructure operations were strong, as was the marketing operation that leverages the assets. And the payout ratio of 45.1 percent is one of the safest around. Insiders are buying Keyera Facilities Income Fund and so should any CE readers who haven’t already, up to USD23.

Macquarie Power & Infrastructure Income Fund (TSX: MPT-U, MCQPF) reported a 55 percent jump in second quarter revenue, the result of last year’s takeover of the former Clean Power. Income from operations surged 29.2 percent. Management projects a 100 percent payout ratio for full-year 2008. That would be high in any other industry, but not selling electric power under very long-term, cost adjusted contracts. Macquarie’s dividend hike earlier this year is a clear sign management intends to keep paying. Macquarie Power & Infrastructure Income Fund shares are cheap and a buy up to USD12.

Northern Property REIT (TSX: NPR-U, OTC: NPRUF) posted a 13 percent increase in distributable income per unit, as it put a 30 percent increase in assets under management to very good use. Growth in resource patch towns such as Fort McMurray keyed the overall results, which combined with a payout ratio of just 71.5 percent seem to set the stage for a dividend increase in the near future. This is one nearly all the Bay Street houses are bullish on and the yield is therefore lower than for other REITs. But given its high quality, Northern is worth the premium. Buy Northern Property REIT up to USD25.

Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF) didn’t increase its distribution in the wake of second quarter results. But its payout ratio of just 41 percent did set the stage for a production increase of 22 percent and debt reduction. Management is confident it can keep doing both even with natural gas prices coming off, thanks in part to an aggressive hedging program. Insiders are buying; for the rest of us, Paramount Energy Trust is buy up to USD10.

Penn West Energy Trust (TSX: PWT-U, NYSE: PWE) second quarter earnings per share were hit hard by losses from hedging–i.e., locking in prices of future output. Those hedges will come in handy in the third quarter, however, keeping realized selling prices at high levels. Meanwhile, the trust continues to cut debt by selling non-core assets, even as it hunts for more acquisitions. There was no dividend increase in the second quarter. But Penn West Energy Trust’s low payout ratio enables debt reduction and the yield of well more than 13 percent should be enough inducement for new buyers up to USD36.

Provident Energy Trust (TSX: PVE-U, NYSE: PVX) has completed the sale of its stake in Breitburn Energy LP, netting a total of CAD440 million after tax to pay down debt. The combination of robust returns at the Canadian midstream and oil/gas production properties pushed the second quarter payout ratio down to just 43 percent. That’s an awful lot of protection for a dividend of more than 13 percent. Provident Energy Trust is a buy up to USD14.

Trinidad Drilling’s (TSX: TDG, OTC: TDGCF) solid share returns this year prove trust conversions to corporations unlock shareholder value, provided a trust’s underlying business is healthy. The drilling industry—and Trinidad shares—remain highly volatile. But the company’s well above average rig rental rates are a testament that its focus on long-term contracts and deep drilling equipment make it a breed apart. The yield’s not as high as it once was, but still attractive. Buy Trinidad Drilling up to USD15.