On Oct. 30, Superior Plus Income Fund (TSX: SIF-U, OTC: SPIJF) became the second income trust to make such a move. And just as in the case with the first—Bonterra Energy Fund (TSX: BNE-U, OTC: BNEUF)—investors have responded with enthusiasm, pushing up Superior shares by nearly 50 percent since. 

In contrast, early converters cutting distributions have taken hits. Share prices have ultimately recovered, provided the underlying business has performed. But management has gotten the message: If they can hold dividends steady, converting from trust to corporation is wildly bullish.

Last month, Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF) became the latest CE Portfolio trust to affirm its intention to hold at least its current payout level well after 2011. And as its robust third quarter results showed, it certainly has the business to back that up.

The conversion issue, of course, isn’t what’s driving trust prices at the moment. As September was stormy for the markets, early October was a true Category 5 storm. And with energy prices declining and driving the Canadian dollar lower, our trusts were right in the middle of it.

The good news is, as of early November, the risk of a worldwide financial collapse has diminished considerably. Instead, the question has become how badly the virtual lending freeze of past weeks has affected the global economy.

As we’ve pointed out many times, Canada’s economy remains on far higher ground than ours. The government has run a surplus for several years. The country’s banks never suffered a subprime lending crisis and remain well capitalized, providing a steady source of lending to companies.

Canada’s overall economic growth turned negative in the third quarter, largely due to US export troubles. But with far less leverage than the US and still very tight employment, the primary impact thus far has been to moderate inflation. That, in turn, has given the Bank of Canada a tremendous amount of flexibility to deal with challenges to growth.

The prospect of slowing global growth has driven down oil and natural gas prices to less than half their midsummer highs. That’s forced several energy producer trusts to trim distributions, and others are likely to follow. Tight credit conditions have also triggered dividend cuts. And at least one prospective takeover has been abandoned because of problems getting financing. 

Unfortunately, these economic pressures aren’t likely to let up for the rest of the year–and very likely well into 2009. The good news: Emerging third quarter earnings are revealing plenty of trusts that are still earning more than enough cash to pay their mighty dividends.

At the peak of the Great Panic in mid-October, business health didn’t matter to many investors. Rather, strong and weak were punished equally as fearful individuals and giant hedge funds alike liquidated their portfolios at rock-bottom prices.

My position in the numerous flash alerts I sent last month was that the worst would be avoided and calm would eventually return to the markets. At that point, money would flow back into trusts backed by strong businesses. My advice was to stick with our positions, unless they clearly demonstrated some weakness.

It’s still too early to tell how effective that approach will be in recovering our bear market losses. I’m very encouraged by the action of the past couple weeks, which has seen several of my favorites surge as much as 40 percent from their mid-October lows. But getting back the rest of the way—and pushing onto higher highs—will depend on businesses’ ability to post consistent numbers.

Thus far into third quarter earnings season, the results for CE Portfolio picks are generally encouraging. And given the fact that our recommendations have already navigated two years-plus of economic and regulatory stress tests, there’s no reason to suspect the rest of the numbers won’t come in equally bullish. Those not analyzed in this issue will be highlighted in flash alerts in the coming days.

Looking ahead to the rest of the year, we have one other thing going for us: low expectations. Despite the rally of the past couple weeks, oil and gas trust shares are still trading about where they were when oil was selling for $30 a barrel or less. Buying them is literally like buying oil at $30 again.

In addition, funds of trusts with enviable, long-term track records sell for less than 80 cents per dollar of assets and yield more than 20 percent. First-rate business trusts—including several boosting distributions in 2008—yield in the mid-teens and higher, and dozens trade at book value or lower.

The lower the expectations, the less it takes to beat them. In my view, just maintaining their high yields pretty much ensures big gains for our favored trusts moving forward. And that’s in addition to the mountain of cash they’ll dish out while we wait.

Global panic selling of stocks accelerated sharply in early October. The Portfolio’s collection of Canadian trusts and high-yielding corporations were hit hard, with US investors suffering a double blow from the steep drop in the Canadian dollar to its lowest level in several years. Over the past couple weeks, the worst of that action has reversed dramatically, including in the Loonie. Making up more ground, however, depends on our picks’ ability to continue posting solid earnings and paying dividends, even as the overall global economy slows.

The Portfolio section reviews earnings from Bell Aliant Regional Communications Fund (TSX: BA-U, OTC: BLIAF), Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF), Consumers Waterheater Income Fund (TSX: CWI-U, OTC: CSIUF), Pembina Pipeline Income Fund and TransForce (TSX: TFI, OTC: TFIFF). Two more—ARC Energy Trust (TSX: AET-U, OTC: AETUF) and new Conservative Holding Great Lakes Hydro Income Fund (TSX: GLH-U, OTC: GLHIF)—are highlighted in November’s High Yield of the Month. The good news is all of these high yielders performed well in the third quarter. Note that Great Lakes is a replacement for Algonquin Power Income Fund (TSX: APF-U, OTC: AGQNF). The latter was sold in the Oct. 21 flash alert after management’s surprise decision to cut its distribution 72 percent. I discuss Algonquin and its prospects in the Portfolio section.

The November High Yield of the Month from the Aggressive Portfolio is ARC Energy Trust (TSX: AET-U, OTC: AETUF). The trust has rallied sharply since simultaneously announcing the rollback of its remaining “top-up” distribution increase and dramatic expansion of its Montney natural gas play. It’s still a model for long-term sustainability in this very volatile industry and continues to trade where it did when oil sold for less than $30 a barrel. The Conservative Portfolio play is Great Lakes Hydro Income Fund (TSX: GLH-U, OTC: GLHIF), which operates a fleet of well-run hydroelectric plants and is backed by solid conglomerate Brookfield Asset Management. Both trusts reported strong third quarter profits, securing distributions and auguring solid results for the fourth quarter and beyond.

How They Rate

Note that How They Rate now features the following trust groups:

Here are advice changes. Note I’ve changed buy prices on a number of trusts this month to reflect the disaster hitting the credit markets and the likelihood of slower economic growth in North America.

See the How They Rate table, as well as for changes in buy targets. Price and yield information is updated every 15 minutes in both tables. Use this service as a reality check when errors occur with US quotes-based services.

Column four of the table shows dividend frequency and the most likely way each trust will minimize 2011 taxation. “Foreign” indicates non-Canadian income, which is not taxed. “Pools” indicate tax pools used primarily by energy producers, which shield income dollar for dollar. “Depreciation” indicates businesses with large non-cash expenses that can be used to shelter cash flow. “None” indicates no visible method of avoiding 2011 taxes, though some trusts have stated their intention to simply outgrow their future liability and maintain distributions.

Algonquin Power Income Fund (TSX: APF-U, OTC: AGQNF)—Buy @5 to Sell. Management pulled an end-run around shareholders with amounts to an effective early conversion to a corporation, by cutting its distribution 72 percent. A straight up move to convert would have required a shareholder vote. The new distribution should be easily coverable with cash flow and will free up money for management’s stated objective of expanding the business. But we don’t like management’s apparent indifference to an overnight halving of the share price, and there are equally cheap and higher-quality alternatives such as Great Lakes Hydro.

Huntingdon REIT (TSX: HNT-U, OTC: HURSF)—Hold to Sell. The credit crunch appears to be getting too much to bear for this REIT. It’s better to get what you can out of it and move on.

InStorage REIT (TSX: IS-U, OTC: INREF)—Hold to Buy @3.25. Management slashed the distribution 56.3 percent to facilitate an asset purchase, suffered a share price decline and now finds itself the target of a hostile takeover offer at CAD3.75 a share. That’s a nice floor for buying a solid business.

Primaris REIT (TSX: PMZ-U, OTC: PMZFF)—Buy @16 to Hold. The retail center business looks increasingly shaky, and there’s no sense owning anything but the best play, RioCan REIT (TSX: REI-U, OTC: RIOCF).

Once taken for granted, companies’ ability to access credit has emerged as a major issue for investors. The good news is trusts have generally eschewed the heavy use of leverage. Before the Halloween 2006 trust tax announcement, for example, trusts were able to issue new equity units in abundance. And almost immediately after that, credit conditions began to tighten in North America, limiting access to debt financing as well. As a result, trusts have been forced to live mostly or entirely on their own resources for over two years. That’s the best indication they’ll weather continued tough liquidity conditions going forward as well. We look at trusts and credit, with a focus on our favorites.

Canadian trusts don’t exist in a vacuum. No matter how well they’re constructed, issues like the health of Asian economies and resource prices will have an enormous impact on future cash flows, distributions and investor returns, particularly over the next year. In this section, we discuss these issues and more with two frequent Canadian Edge contributors: The Energy Strategist editor Elliott Gue and The Silk Road Investor editor Yiannis Mostrous.

This section features short bits on a wide range of topics. For more evergreen and tutorial items, see the Subscribers Guide “Subscriber Tips” section.

Dividend Watch List—Not surprisingly, distribution cuts picked up over the past month. In the energy patch, the cutters were Canadian Oil Sands Trust (TSX: COS-U, OTC: COSWF), Enerplus Resources Trust (TSX: ERF-U, NYSE: ERF) and High Yield of the Month ARC Energy Trust. CI Financial Income Fund’s (TSX: CIX-U, OTC: CIXUF) decision to convert to a corporation triggered its 76.5 percent cut. Meanwhile, Algonquin Power Income Fund’s (TSX: APF-U, OTC: AGQNF) decision to effectively convert without shareholder approval triggered a 72 percent cut. A now settled strike interrupted distribution payments from FP Newspapers Income Fund (TSX: FP-U, FPNUF). Exposure to credit pressures and weakening economic growth were the primary culprits for reductions at GMP Capital Trust (TSX: GMP-U, OTC: GMCPF), Huntingdon REIT (TSX: HNT-U, OTC: HURSF), InStorage REIT (TSX: IS-U, OTC: INREF) and Newport Partners Income Fund (TSX: NPF-U, OTC: NWPIF).

Bay Street Beat—How the Canadian analyst community views trusts, including our favorite trusts.

The following is a regular repeat from prior issues.

Use our live quote feed on the How They Rate Table for US dollar prices of trusts intra-day. For other information, go directly to a trust’s website by clicking on its name in the table. Clicking on the Toronto symbol (suffix “.UN”) will take you to the web site of our Canadian partner Toronto-based MPL Communications (133 Richmond St. West, Toronto M5H 3M8) www.adviceforinvestors.com, which has price charts and access to press trust releases. For questions and comments, drop us a line at canadianedge@kci-com.com. Check out the Toronto Stock Exchange Web site for a range of information on income and royalty trusts. The Web site www.sedar.com is an online library of documents filed by trusts with the Canadian equivalent of our Securities and Exchange Commission. The Toronto Globe & Mail features the “Globe Investor” section with all the latest news on trusts. Dominion Bond Rating Service is the pre-eminent credit rater for trusts. The Bank of Canada Web site features a handy currency converter for Canadian dollars and US dollars into 50 other currencies around the world, and it’s a great source of free information on the Canadian economy.

Note the NAFTA challenge to the Government of Canada’s “Tax Fairness Plan” is heating up. Interested investors should contact: http://www.naftatrustclaims.com. Also, for late filers, the Income Trust Tax Guide has all the backup you need to file distributions as “qualified dividends.”

Roger Conrad
Editor, Canadian Edge