The CCS buyout highlighted the takeover appeal of High Yield of the Month Newalta Income Fund (NAL.UN, NALUF), which also cleans up waste from energy and industrial sites. And it likely portends more management-led deals with private capital help.

Private capital itself remains hyperactive in the trust market. GMP Capital Income’s (GMP.UN, GMCPF) Edgestone unit, for example, is partnering with one of the CCR players—Goldman Sachs—to buy a major film distributor trust. Meanwhile, Sun Life Financial has restored its interest in CI Financial Income Fund (CIX.UN, CIXUF) to 36.5 percent, possibly portending a full buyout before 2011.

Thus far, every buyout accepted by management has been completed swiftly unless it was trumped by a higher offer. Canadian regulators even seem unlikely to block a private-capital takeover of telecom giant BCE. That passivity may not last forever, as foreigners continue to gobble up larger and larger slices of the country’s economy. And certainly no one should count on a takeover of trusts they own.

But as the size of these merger premiums indicates, takeover potential isn’t yet being baked into trust prices. As long as that’s the case, there’s little downside in the unlikely event the flow of private capital unexpectedly slows down. And mergers will continue to produce big gains for those who buy trusts backed by strong businesses.

Last month, the Canadian parliament passed the Conservative Party’s budget, along with the provision to begin taxing income trusts as corporations beginning in 2011. The market’s decidedly ho-hum reaction to the news should come as no surprise because prospective taxation has been fully factored in and then some to trusts’ prices since mid-November.

What’s still not reflected is the fact that many trusts will largely escape the negative impact of taxation on their distributions. The average Canadian corporation, for example, pays less than 7 percent of income in taxes, rather than the posted 31.5 percent rate. In the June Feature Article, I focused on tax pools and foreign-based income as ways to dodge future taxes. This month, I look at a third method: organizing some or all of a trust’s assets under a US-based limited partnership.

As we look ahead to the second half of 2007, there are plenty of wild cards for Canadian trusts, including volatile interest rates and energy prices. On the political front, a Liberal Party victory in still unannounced, but inevitable elections would bring both a drop in prospective trust taxation to a maximum rate of just 10 percent and tougher environment regulation in the energy patch.

These factors are all beyond our control as investors. But as long as we buy and hold trusts backed by good businesses, we’ll continue to collect big cash flows and ultimately reap the benefit of solid share growth as our trusts become increasingly valuable.

Setbacks along the way may be occasionally nasty and brutish. But they’ll also be definitively short and followed by robust recoveries to higher highs.

Portfolio Action

Most Conservative Portfolio and Aggressive Portfolio holdings finished the month of June lower because of rising US interest rates and weakness in natural gas prices. Nonetheless, the news flow on the fundamentals was positive, and our holdings gave every indication they’ll be reporting robust second quarter results in the next four to six weeks. I’m adding another Conservative Portfolio holding: Energy Savings Income Trust (SIF.UN, ESIUF). Buy targets generally remain the same in anticipation of second quarter results.

High Yields Of The Month

The July Conservative High Yield Of The Month is new holding Energy Savings Income Trust, which sells for basically one times sales despite robust cash flow growth. Distributions were raised 4.5 percent last month, the 27th increase since its initial public offering in April 2001. The Aggressive Portfolio High Yield Of The Month is Newalta Income Fund, which has gained takeover appeal in the wake of CCS’s management buyout.

How They Rate

I’m adding two selections to How They Rate coverage this month: Wholesale fuels trust Parkland Income Fund (PKI.UN, PKIUF) and Royal Utilities Income Fund (RU.UN, RYUTF), the largest provider of thermal coal to Canadian utilities. Coming off the list are now-acquired trusts Great Lakes Carbon Income Fund and KCP Income Fund. Note Canada Cartage (TRK.UN), Clean Power Income Fund (CLE.UN, CEANF), Custom Direct Income Fund (CDI.UN, CUDFF), Thunder Energy Trust (THY.UN, THYFF) and UE Waterheater Income (UWH.UN) have either completed mergers or will in the next couple weeks. As a result, they’ll be coming off the list in either August or September.

Here are my advice changes. See the How They Rate or the Portfolio tables for changes in buy targets. Price and yield information is updated every 15 minutes on both tables:

• CI Financial Income Fund (CIX.UN, CIXUF)—From hold to buy up to 26. The beefed-up interest of a major owner ignites takeover appeal for this exceptionally steady trust.
• Countryside Power (COU.UN, COUUF)—From hold to sell. The CD9.60-per-share takeover by a private-capital firm isn’t at a particularly high premium, and the risk of failure is also low. But with the trust losing a third of its income and facing challenges from California regulation and reinvestment from the US Biogas settlement, taking the money and running is the wisest course.
• Crescent Point Energy Trust (CPG.UN, CPGCF)—From hold to buy up to 20. The trust’s position in the Baaken region looks stronger than it first appeared. The second quarter payout ratio should benefit from the Mission merger.
• Dundee REIT (D.UN, DUNTF)—From hold to sell. General Electric’s buyout fully prices this REIT at CD47.50 per share in cash.
• InterPipeline (IPL.UN)—From hold to buy up to USD9. Purchase of a pipeline system from now-privately held Kinder Morgan will immediately boost cash flow and points the way to future expansion.
• Primary Energy Recycling (PRI.UN, PYGYF)—From sell to hold. Conservative investors should still stay away, but a new credit deal will hold the current payout at least until the second quarter of 2008.
• Superior Plus Income (SPF.UN, SPIJF)—From hold to buy up to 15. Propane operations were the first quarter stars, but other divisions are turning around quickly.
• Versacold Income Fund (ICE.UN, VCLDF)—From hold to sell. Odds of a higher bid than the CD12.25 per share in cash offered by Eimskep now appear dim. Rather than going through the hassle of tendering shares, it makes sense to sell now that the likely last ex-dividend date (June 29) has passed.

Feature Article

Tax pools and foreign income are two ways trusts will reduce their tax burdens for 2011 and beyond. The Feature Article looks at a third, more-speculative option: placing all or a portion of assets and income under a US-based master limited partnership. With oil and gas trusts trading at steep discounts to US-based limited partnerships (LPs) producing energy, the first trust to go LP will trigger a major move up for trusts’ prices across the board. 

Because going all LP entails a number of hurdles, more trusts are more likely to shelter only their US income by putting US-based assets into LPs, as Provident Energy Trust (PVE.UN, NYSE: PVX) has. For trusts with heavy US exposure, the savings from going to LP status would dwarf additional 2011 burdens in Canada.

Canadian Currents

Last month, the Conservative Party government passed its budget, including the so-called Tax Fairness Plan taxing income trusts like corporations beginning in 2011. Nonetheless, that’s far from the final word on the issue. The Liberal Party has made reducing the prospective trust tax to 10 percent a major campaign pledge.

We look at how Canadian politics and the trust issue is shaping up here in mid-2007. The best news is, with trusts pricing in full taxation, any change in the law means a windfall for investors. Note that complementary product Maple Leaf Memo, free to CE readers, covers these developments every week along with updates on specific trusts.

Tips On Trusts

This section taps our take on a wide range of topics. For more evergreen and tutorial items, see the Subscribers’ Guide Subscriber Tips section.

Dividend Watch List—No trusts in the Canadian Edge universe reduced distributions in June. And with energy prices firming and most bad trusts already bombed out, we’re not likely to see many in coming months either, even as many trusts boost payouts. I’m adding Clearwater Seafoods Income Fund (CLR.UN, CWFOF) and Noranda Income Fund (NIF.UN, NNDIF) to the list because of operating problems.

ETF Loon-acy—I’m very bullish on the energy price-sensitive Canadian dollar as long as the bull market in energy lasts, which should be at least several more years. But here’s an exchange traded fund that will allow you to protect your holdings from an unexpected fall in the Canadian dollar.

Bay Street Beat—How the Canadian analyst community views trusts and how to use that information.

More Information

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.

Roger Conrad
Editor, Canadian Edge