Hedging Our Bets on Investing for Income Between Credit and Inflation Risk

Condensed Version of
HEDGING OUR BETS
by Roger Conrad
Editor, Utility & Income
October 9, 2007

Income investments come in all shapes and sizes. But all have one thing in common as far as we’re concerned: We’ve got to buy and hold ‘em to get the most out of them.

Part of that is axiomatic. You can’t collect the distributions unless you stick around for them to be paid. Individual bonds are the exception because they accrue interest as long as you hold them. But as far as stocks, Canadian trusts, limited partnerships, income-paying funds, preferred stocks or anything else goes, you’ve got be in there on the ex-dividend dates or you won’t get paid.

Ironically, the most important reason income investors need to buy and hold is capital appreciation. A healthy, growing company will increase its dividend over time, and its share price will follow. If you’re trading, you won’t get that gain unless you’re very, very lucky.

Buying and holding, of course, isn’t without risks. For income investors, there are basically two: credit risk and inflation risk.

The former has been on investors’ minds this year. And virtually anything perceived as having too much debt—or too unorthodox a capital structure—has taken hits.

There are two ways to protect your portfolio against credit risk. One is by sticking only to high-quality, growing companies and shedding anything where the business fundamentals are weakening. The other is to diversify broadly, both in terms of individual stocks you hold and across market sectors.

When the markets are universally panicked about recession or a credit crunch, big institutional money will pretty much sell off anything that doesn’t have the word “Treasury” in it. And that’s exactly what happened on the worst days over the summer.

The key in a market like that is to avoid the real blowups, i.e., the companies that are really in trouble. This time around, that was basically financial companies that had gotten in really deep in the mortgage market and/or collateralized debt obligations. As JP MORGAN CHASE’S $5.5 billion writeoff announced today illustrates, there are still some landmines in this area, though that stock is actually up today.

In contrast, damage to most other income investments in recent months was largely because of guilt by association. Limited partnerships (LPs), for example, were walloped by concerns about their debt structures and whether or not they’d be able to access capital markets. Both fears have proven largely groundless, at least for the best quality LPs. As a result, money is starting to flow back in and shares are recovering.

The lesson: If you avoid the blowups in an environment of elevated credit risk, your losses will be short-lived. In fact, such times are golden opportunities to buy high-quality income stocks cheaply.

THE GREATER RISK NOW IS INFLATION - ESPECIALLY IN THE USA

The bottom line is, if you pick your stocks carefully, diversify well, shed holdings that weaken business-wise and are willing to be patient in downturns, you can make your income portfolio pretty much foolproof against credit risk.

Guarding against inflation risk, however, is a whole other matter. Income-oriented investments are especially vulnerable to inflation because they’re valued to a large extent on the basis of yield. Rising inflation pushes market interest rates higher, which makes those yields worth relatively less. As a result, income-oriented investments sell off to a point where yields are again attractive.

During the 1970s, Treasury bonds were among the absolute worst investments to own. Credit risk was zero.

But every incremental increase in inflation made investors demand a higher yield to compensate for the erosion of principal. And by the time inflation peaked in the late ’70s and early ’80s, bonds issued at the lower rates of the ’60s had lost most of their real value.

We haven’t had a real inflation problem in the US since those bad old days. We have, however, had occasional flare-ups that have wreaked havoc on everything from REITs to utilities.

In each of the past five years, we’ve had a spring or summer spike in interest rates, as investors have anticipated faster growth and higher inflation. The benchmark 10-year Treasury note yield spiked, and income investments across the board sold off. Each time—including this year—rising rates sowed the seeds of their own reversal, sparking worries about the economy and ultimately sending them lower.


As we move into the fourth quarter, rates are down and credit worries are receding. As a result, income investments are starting to recover their summer losses. That rally should continue throughout the fourth quarter. Utility stocks, for example, have had a positive fourth quarter in 35 of the last 40 years.

After that, however, the future gets considerably cloudier. With the Federal Reserve apparently willing to do whatever it takes to avoid recession, credit risk is no longer the primary concern. Rather, it’s inflation. And the more money the Fed and other world central banks pour into the system now to bail out the likes of JP Morgan, the greater the risk.

One way income investors can protect themselves against inflation is healthy growth. Not even companies that can grow dividends reliably and robustly have historically been able to hold their share value in the face of rapid inflation. But they do a credible job with moderate inflation, if for no other reason than investors need to get their income from somewhere.

How bad can inflation get this time is the $1 million question. And as is always the case with market economics, that’s impossible to forecast.

What we do know, however, is there are investments that pay moderate income and actually do very well in inflationary environments. By adding them to already diversified portfolios, we can cut the inflation risk to our overall portfolios.

What I’m talking about are metals and other vital resources. Over the past five years or so, many of the raw commodities—from copper to zinc—have doubled and tripled in value. The primary reason is global growth.

Not since the ’70s has the world seen such robust, synchronized economic growth. And unlike then, the US isn’t the only driver of growth this time around.

We’re still the most important economy. But China, Japan, Europe, India and the Middle East are also driving things. That makes this growth wave a lot more durable than the last one. In other words, a US recession would no doubt slow things down, but it wouldn’t derail global growth as it did in the early ’80s.

Metals and other raw commodities are the essential fuel for global growth. And the faster and more universal growth is, the greater the strain on supplies. Already, we’ve seen Russia plant its flag on the North Pole, while China and Europe are snuggling up to African dictators and the regime in Iran. And that’s only the beginning, as competition for scarce resources grows.

Eventually, every commodity cycle ends. Ever-rising prices induce consumers to change their habits and develop alternatives, even as they incentivize new discoveries. The process, however, can take years and even decades before the supply/demand balance shifts back in favor of consumers, and it’s never entirely painless.

One of the hallmarks of a top in a commodity cycle is breathless speculation that supplies are truly running out. I’m not hearing any of that now in the financial media.

In fact, the buzz is largely about how the commodity bull has reached unsustainable levels and that its days are numbered. This is in stark contrast to what’s happening in the market place, and the disconnect likely points to a lot more ahead.

Commodities and vital resources are good inflation hedges for one major reason: They represent hard value. Gold, for example, has been a global store of value for millennia. When US inflation undermines the value of paper money, gold holds its own—mainly by surging in US dollar terms.

The best way to play a boom in commodities and vital resources is to buy stocks of the companies that produce them. For one thing, gains are leveraged. For example, a company producing copper at a total cost of $1 a pound will see its earnings double if the metal moves from $2 a pound to $3 a pound—a 50 percent gain in the metal itself. And good companies are always growing, providing a rising base of earnings.

I’ve already been talking about high-yielding energy bets like Canadian trusts, Super Oils and combination utility/producers for some time. We’ve seen some staggering profits in these over the past five years or so. And until we see the factors that ended the ’70s energy bull market in abundance—greater conservation, switching to alternatives (not biofuels), new conventional reserve discoveries (not from oil sands or extreme deepwater drilling) and a global recession—we’re going to see a lot more gains.

The takeover offer for Canadian trust PRIMEWEST ENERGY TRUST by the ABU DHABI NATIONAL ENERGY CO—which was at nearly a 40 percent premium to the pre-deal price—is a pretty clear value alert for that sector. And whether it means takeover for the likes of other strong trusts like Enerplus Resources or Penn West Energy Trust or not, it does add up to big gains ahead for the best trusts, in addition to their high distributions.

Energy is only one resource that offers income investors an inflation hedge.

Canada Under Seige: Thanks Harper and Flaherty

The Trust tax hoisted onto Canadians is facilitating the transfer of our wealth from Canadians and hard working Americans who invested in our income trusts.

We at investingforincome are not just a bunch of malcontents about getting screwed by our government. But everyone is getting screwed. What is really sad is that part of the reasoning behind the "Tax Fairness" was that our American friends were benefting from the trusts and they called that "tax leakage". Our reflex anti-Americanism has resulted in our wealth being transfered to an Arab government.

Below is a copy of Diane Francis's BLOG on this issue. If you click the title of this post you will be taken to her BLOG.

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By Diane Francis

Canadian policies are facilitating the buyout of Canada. Canadian energy trusts are bought with 100% financing borrowed from foreign lenders or entities. Interest payments are made from Canadian cash flow which used to be distributed to trust unitholders and taxable.

The interest payments to foreigners are also exempt from the 15% withholding tax. This means that taxable cash flow has become tax-free mortgage payments to buy energy assets.


Abu Dhabi pounced first and in months will be the biggest oil company in the land, financed in this way by taxpayers. To boot, not one share of its oil entity in Canada, TAQA North, can be owned by a Canadian under Abu Dhabi law.

The Dirty Little secret About the Prime West Energy Energy Trust Buyout by the Arabs

Today an Arab country bought out Prime West Energy Trust for a 30% premium. The dirty little secret is that Prime West will now become a "private" flow through entity and will not be subject to a the "Trust Tax".

This is absolutely insane and I am amazed how our media and the public are so naieve that they cannot see what hyprocisy this tax is.

Remember, the "Tax Fairness" policy was designed only to Tax publicly traded Trusts.

This is patently unfair.

Ironicly, the Canadian Minster of Finance sometimes advertises the tax fairness plan on this blog. What a Croc!

The Right Market at The Right time

Below is an article published by Roger Conrad an American newsletter writer. I think he is being overly optimistic about Canadian Income Trusts but I figure my readers may find his article interesting.

Some of his comments with respect to the Trust tax legislation are out of date so I edited those portions out.

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THE RIGHT MARKET AT THE RIGHT TIME
by Roger Conrad Editor, Utility & Income
April 4, 2007

Remember when investors could retire and live well on a modest nest egg? Remember when taxes were only 15% a year, and when you didn't have to worry about losing your shirt before the closing bell?

That way of life has gradually been taken from you. But this letter is going to bring it all back, courtesy of the Canadian government.
They've invented a whole new kind of investment, one that's pulling hundreds of billions of US dollars across the border into Canada today.In a nutshell, Canadian Income Trusts are a brilliant structure that allows a business to avoid taxes--all taxes.

That's one pretty obvious reason they're so popular.The other big reason is that by Canadian law, nearly all the earnings from a trust business must flow right through to its investors, which in this case means you.

You no longer have to settle for the bread crumbs we call "dividends" here in the South 50!Here's how trusts work up North: A trust uses what it receives from its product sales to pay general expenses and service any debt, and it also sets aside a little bit for exploration or development. Trusts are very careful to set aside no more than 15% of their gross profits, so at least 85% normally goes directly to your mailboxevery month. In other words, you usually get a check for about 85% of the true earnings. Sometimes it's near 100%!Life doesn't get any smoother than that.

Canadian income trusts aren't structured for the benefit of their CEOs, but their shareholders.

What a concept!

Canadian Income Trusts: A Screaming "BUY" Opportunity

On Halloween day last year, Canadian Finance Minister Jim Flaherty decided that no more companies should be allowed to convert into trusts and that virtually all existing trusts should lose their tax-exemption starting in 2011.

Four years is an eternity in politics. It gives Canadian authorities plenty of time to allow certain businesses back into the income trust fold. (I'm convinced that what they really want is to restrict the format to the natural resource companies it was intended for--not to kill the trust format altogether.)

A year from now, I bet we'll barely remember this Halloween scare. And look on the bright side: It's hard to lose if you buy in now.

Trust prices have fallen in the face of uncertainty, giving you a great entry point and super-sized yields. Trusts that were yielding 10% the day before Halloween are now paying 12%. The actual businesses underlying these trusts haven't changed a bit. Conservatively run, high-quality income trusts are as solid as ever, and I have no doubt they'll prevail for years to come.

Remember, the current yields still hold until 2011. So the owners of Precision Drilling, just to pick one of my favorites, will still receive 13.2% on their capital for the next four years. And even if they're taxed four years from now, these companies will still be paying yields that dwarf your options in the Dow and S&P. Dozens of trusts now yield more than 10%, some as high as 21%.

Bottom line: I'm pounding the table because there are still plenty of trusts worth buying and holding for the long haul as their businesses grow.

Income Trust Tax not as bad as some think

The income trust taxation announced by the Canadian Government on halloween 2006 is somewhat misunderstood.

1) Canadians in the highest tax bracket who hold their trusts in a taxable account will see little if any decline in after tax income. However, Canadians with little or no taxable income (ie the dividend tax credit is non-refundable) will feel the full effect of the trust tax. This Trust tax actually screws the low income investor and investors who have retirement accounts.

2) USA investors with trusts in the non-taxable accounts will find that there will be no more 15% withholding tax on distributions that will go into that account, reducing the net effect of the Trust tax up to 50%.

3) USA investor placing certain trusts into a retirement accounts, they will be hit with little or no tax (except for tax paid by the income trust under the new trust tax regime) and no 15% withholding tax, which is somewhat better than investing in the current income trust structure.

4) Some investors are under the mistaken impression that the distributions of all trusts will decline by 31.5% starting in 2011. That is not necessarily true. There are oil and gas, pipeline, power and other infrastructure income trusts that will pay no tax or minimal tax for years after 2011 due to tax pools and depreciation allowances on assets.

5) It appears the income participating units (units that consist of a common share plus a bond "stapled" together) will not be affected by the trust tax. If this strtucture is allowed I think we will see some existing trusts convert to this structure and new IPO's issued using this structure.