In this issue:

BEATING THE TRUST TAX

By Gordon Pape, Editor and Publisher

The trust market in Canada was decimated by the introduction of the SIFT tax, which came into effect on Jan. 1 last year. But it is not dead yet. The REIT sector was largely unaffected by the tax, a few trusts have moved offshore, and some of the old ones chose not to convert to corporations.

Especially interesting has been the creation of some new trusts which have been structured in such a way as to avoid the new tax. Whether Ottawa will tolerate them for long is problematic, especially if the industry gets too aggressive and tries to rebuild the sector by taking advantage of a loophole in the SIFT rules. (SIFT is the acronym for specified investment flow-through, which covers most income trusts and limited partnerships in Canada.)

So are these new tax-busting trusts worth considering? I analyzed two of them and here’s the story.

Eagle Energy Trust (TSX: EGL.UN). Eagle avoids the SIFT tax by listing its units in Canada but holding only U.S.-based assets. Management’s strategy is to focus on producing properties – the trust will not engage in extensive exploration activities. The current focus is on the old Salt Flat Field in south central Texas, which was originally discovered in 1928. Eagle is using conventional horizontal drilling techniques to tap into previously unexploited reserves.

This is still a fledgling operation. As of the end of 2011, Eagle was producing only 2,425 barrels of oil per day (bbls/d), all of which is light sweet crude. Target for this year is an average of 2,600 bbls/d. Management estimates there are adequate reserves to maintain the current operation and level of distribution for three years. It’s not clear at this point what will happen after that. Management is only saying that it is seeking to acquire other producing properties in the U.S.

Distributions are being paid at the rate of $0.0875 per unit each month ($1.05 per year). In a guidance statement issued on Dec. 5, management said that it expects funds from operations of $40 million in 2012, assuming an average price of US$88 per barrel. If this turns out to be accurate, the payout ratio would be 50%.

The market isn’t so sure about that and is pricing a high degree of risk into Eagle. The units closed on Jan. 20 at $10.34 for a projected yield of 10.2%, if the distributions are sustained. That’s an attractive payout and some of the money will be received as tax-deferred return of capital in non-registered accounts. But the size of the company and the short-term viability of its current operation make this a high-risk play.

Parallel Energy Trust (TSX: PLT.UN). This is another new trust (prospectus filed in March 2011) which has been structured to avoid the SIFT tax in the same way as Eagle. Parallel’s initial investment is in a natural gas and gas liquids property located in the West Panhandle Field in Texas. It is part of the Hugoton gas field, the largest conventional gas field in North America.

The trust completed an initial public offering worth $393.3 million gross in early May, issuing 39.33 million shares at $10. The proceeds were used to purchase a stake in a West Panhandle property. Parallel owns 59% of Bravo Natural Gas LLC’s Panhandle asset, which is located in the Carson, Hutchinson, Moore, and Potter counties of Northern Texas. The Panhandle acreage consists of approximately 290 producing wells. The company says it also offers exploitation and development opportunities.

The share price touched $11 in mid-May and then went in to a prolonged decline, bottoming out at $6.80 in mid-December. It has since rallied back to close on Jan. 20 at $8.26.

Given its brief history, we don’t have a lot of information available to enable us to judge Parallel’s long-term potential. Third-quarter production averaged 3,662 barrels of oil equivalent per day (boe/d), most of which was in the form of natural gas and natural gas liquids.

The trust reported revenue net of royalties of $13.4 million for the quarter. Funds from operations came in at $9.1 million and the trust reported net income of about $5.8 million.

In late November, management announced that the trust has established a capital expenditure budget of US$16.5 million for 2012 and set a production target of between 4,600 and 4,800 boe/d for the year. Of that, 1,600 boe/d has been committed under hedging agreements which set a floor price of US$4.20 per mmbtu for natural gas, US$54 a barrel for natural gas liquids, and US$92.50 a barrel for oil.

The trust currently pays monthly distributions of $0.075 per unit ($0.90 a year). At a price of $8.26, that projects to a yield of 10.9% over the next 12 months. In a recent research report, associate analyst Jennifer Dowdell of RBC Capital Markets said she estimates that will amount to a payout ratio of 112% in 2012 which is high but “manageable”.

Personally, I distrust payout ratios that are higher than 95%, especially in the case of new entities such as this. The market obviously is thinking along the same lines, which is why the units are priced to produce such a high cash return.

Like Eagle, Parallel offers high cash flow and the potential for price appreciation but the risks are much higher than for well-established companies such as ARC Resources and Canadian Oil Sands. Therefore only investors who are willing to accept a higher degree of risk should consider these newcomers.

Please note that these are not formal Income Investor recommendations as both are too risky for our normal parameters. Therefore we will not be tracking performance on an on-going basis.

Gordon Pape’s new book, Retirement’s Harsh New Realities, can be purchased through our on-line Best Books store, which is associated with Amazon: http://astore.amazon.ca/buildicaquizm-20. It is also available in e-book formats for Kindle, Kobo, and other readers.

Follow Gordon Pape’s latest updates on Twitter: http://twitter.com/GPUpdates

 

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A LOOK AT RETRACTABLE PREFERREDS

By Tom Slee, Contributing Editor

There are plenty of variables and unknowns as we go into the New Year but one thing seems certain: The central banks are going to keep a stranglehold on interest rates. They have no choice. Economic activity here and in Europe is actually slowing in what was to be the third full year of recovery. For instance, we are looking at Canadian GDP growth of about 1.8%, down from 2.3% in 2011 – and that is one of the brighter spots.

So bond markets are likely to move sideways for the foreseeable future. As a matter of fact, the U.S. Federal Reserve is committed to exceptionally low rates until at least the middle of 2013. On Jan. 9, Germany’s Federal Finance Agency issued six-month Treasury bonds with a minus 0.12% yield. That’s right, a negative 0.12%. People are paying the government to look after their money!

It’s a sombre outlook as far as fixed-income investors are concerned, especially while North American stocks remain a question mark. It also means that we will have to look for opportunities outside the mainstream markets in order to boost our returns. REITs, preferred shares, and some of the remaining income trusts are more likely to provide attractive situations than conventional bonds. Even now blue-chip Canadian straight preferred shares are yielding 200 basis points more than comparable corporate debentures. Moreover, preferreds come with all sorts of bells and whistles so you can choose one that suits your requirements.

To give you an example, the mostly overlooked retractable preferred shares provide what is essentially a maturity date. You have the option of selecting the term and cashing in at a predetermined price. Here is some background.

Preferred shares have never been fashionable for several reasons. First, they are hybrids, in effect equity with a fixed dividend and no earnings participation – call them quasi bonds, if you like.

Second, there are relatively few of them because corporations normally finance their operations with bonds and stocks. As a result, preferred share trading is fairly thin. So brokers and advisors focus on stocks or, more likely these days, mutual funds.

Third, and perhaps most important, over the years there has been little spread between preferred share and bond yields. As a result, small fixed-income investors and institutions have tended to favour bonds with their guaranteed principal repayment, greater liquidity, and broad choice.

These days, though, we have an unusual situation. Canadian and U.S. bond markets are essentially capped with yields near record lows right across the spectrum. As I write, two-year Government of Canada bonds are yielding 1%, with inflation running at 2.3%. That represents a negative return even before taxes. At the other end of the curve, 10-year corporate debentures are paying 3.25%. By comparison, the Canadian Utilities Straight Preferred Shares Series W, is priced at $25.80 and yields 5.6%, which is 235 basis points more.

Of course, bonds and preferred shares are not strictly comparable. Bonds have a maturity date with a guaranteed repayment of the par value in full. Straight preferreds are perpetual, in other words open-ended, and you have to sell them into the market in order to recover your capital. There are, however, some issues that carry a retractable provision. The investor can redeem the shares on a predetermined date for a specific value. These shares have what amounts to a maturity date. Some investors may find this feature attractive.

A word of caution, however, about retractable preferreds: Read the small print carefully. These issues are divided into two categories. “Soft” retractables allow the company to pay an investor in cash or common shares when called, which to some extent turns the shares into convertibles. In fact, they trade that way. To give you an example, the Brookfield Properties Series H Preferred Shares are retractable at $25.60 and yield a relatively high 5.6%. That is because the company can pay investors with common shares when they exercise the retraction feature on or after Dec. 31, 2015. As you can see there is a stock market element built into the current price.

The “hard” retractable shares, a much smaller category, are clearer cut and give an investor the right to sell the shares for cash. They are similar to bonds and as a result yield less than “soft” issues in the present environment.

My suggestion is that readers who want a fixed-term investment should opt for “hard” preferred shares. One issue that I like right now is the Canadian General Investments Class A, Series 2. It’s my January Top Pick and you’ll find all the details elsewhere in this issue.

Canadian Bond Investors Association

Turning to another front entirely, I was very pleased to see the recent formation of a Canadian Bond Investors Association. This is very good news for small fixed-income investors. Normally I am not a fan of committees and commissions but bondholders in this country have been treated as second-class citizens for far too long. We need a voice. In theory we are senior to shareholders in the investment world and supposedly our rights are fully protected. However, as we saw during the infamous BCE buyout negotiations in 2008, that is not how our courts see things. The new Association is a first move to put things right.

As you may recall, almost four years ago the Ontario Teachers’ Pension Plan launched a leveraged buyout bid for BCE. The offer of $42.75 a share was 40% above market, a $10 billion bonanza for the common shareholders.

Later, Teachers agreed to take out the preferred shareholders at a premium. But there was one snag. The deal saddled BCE with $34 billion in additional debt which, in effect, reduced all of the company’s outstanding bonds to junk status. As a matter of fact, the existing bondholders, who had not been consulted, saw the value of their supposedly top-quality investments plummet. After their protests were ignored they launched a lawsuit against BCE but lost. The Supreme Court of Canada ruled that boards of directors are required to maximize shareholder profit, even if bondholders are hurt.

Institutional money managers have stewed over that decision ever since. Now they are going to do something about it by combining their purchasing power to exert influence on the bond issuers. They want safeguards against risks created by corporate restructuring. In future, bondholders should have the right to participate in any privatization and even voting rights under certain circumstances. Perhaps most important, the major bond buyers want a say in an underwriter’s terms and conditions. As one leading bond manager pointed out: “When a new issue comes you get 20 minutes notice to get your order in.” There is no discussion of covenants and indentures. That has to change.

The new association also plans to apply pressure on the banks. They have been issuing increasingly arcane fixed-income securities in order to beef up their T1 capital, sometimes exposing investors to poorly explained risks in the process. For example, the new non-viable contingent capital bonds convert to equity when a bank’s T1 capital falls below a certain level and presumably the bank is in serious trouble. If that happens, the conversion feature is possibly worthless and is certainly devalued. Arguably the banks are not warning the public about this threat.

Another problem on the association’s agenda is a protest about the bill now before Parliament that would place pensioners ahead of bondholders in a corporate bankruptcy. This could be the start of a slippery slope that would eventually reduce bondholders to unsecured creditors competing with trade payables. There is a lot to do and it would be good to see more clarity and protection in what is an almost unregulated bond market. We would all benefit.

Tom Slee managed millions of dollars in pension money for many years and is an expert in fixed-income securities.

 

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GAVIN GRAHAM REVISITS PAST PICKS

By Gavin Graham, Contributing Editor

The start of a New Year is always the traditional time to review the performance of past selections. Let’s begin by looking at how my recommendations performed in 2011 and whether there are any underlying themes that emerge that may be helpful for this year.

This review will be in two parts. In this issue, we’ll examine those picks that outperformed the S&P/TSX Composite’s -9% return for the twelve months to Jan. 13th, 2012 (-7% after taking dividends into account). Then we’ll look at those that underperformed the index in the February issue.

Last year ranked amongst the worst years for equity returns in the last decade, surpassed to the downside only by 2008 and 2001-02. Investors’ optimism at the beginning of 2011 translated into a rise in the markets through April, at which point the indexes had doubled since their lows in March 2009.

But during the summer it became apparent that the debt crisis in the eurozone had not been successfully addressed by the initial bail-out package in May 2010. That crisis combined with the budget standoff in the Washington, which contributed to the U.S. losing its AAA rating in August, shook investor confidence to the core. Stocks plummeted through the third quarter, resulting in a full-fledged bear market with indexes down 20% from their highs.

Some positive actions by the European authorities finally restored a measure of confidence, which was reinforced by improved growth in the U.S. and the first declines in interest rates and reserve requirements in emerging markets. That sparked a rebound in the fourth quarter. The Dow Jones Industrials Average, which is comprised of blue-chip companies with good balance sheets, was the only developed market index rise during the year, gaining 8%. The S&P 500 Index in the U.S. was flat. Every other major developed and emerging index was down between 5% and 25%.

Government bond markets outside of the eurozone were the beneficiaries. Investors looking for perceived “safety” were willing to lend their hard earned capital to governments with enormous budget deficits and challenging demographics for up to 10 years for less than 2%. In the case of Japan, the country with the biggest deficit and the worst demographics, the return was less than 1%! The one investment certainty over the next decade is that these investors will suffer a real after-inflation loss of their principal.

This approach seems particularly unattractive when compared to the higher nominal yields available on good quality equities of varying market capitalization. Plus, they enjoy the benefit of being able to at least keep up with inflation by raising their dividends. Let’s examine some of these stocks now.

The recommendations that did best last year were principally those which benefited from the low interest rate environment while providing a stable and possibly growing yield, namely utilities, pipelines, and REITs. This will not be any surprise to Income Investor readers but it’s remarkable just how well these sectors performed compared to the more economically sensitive areas of energy, materials, and industrials.

My best performing recommendation was Alberta pipeline and energy company AltaGas (TSX: ALA, OTC: ATGFF). It produced a total return of 39% including a 5% yield as improvements to its pipeline network were complemented by some of its renewable energy projects beginning construction or coming on stream.

Other contributors’ Income Investor pipeline recommendations such as Enbridge (TSX, NYSE: ENB) and TransCanada Corp. (TSX: NYSE: TRP) produced 33% and 18% total returns respectively. This proved that regardless of potential political delays to new pipeline projects such as Keystone XL and Northern Gateway, the regulated utility model remains attractive.

Action now: I said last summer that AltaGas could be a sell due to its strong performance. That is still the case. If investors are concerned about the outlook for the economy and markets then it would make sense to take some profits here. Otherwise, AltaGas remains a Hold.

The telecom stocks were also strong performers. Telus and BCE (both recommendations of our companion Internet Wealth Builder newsletter) gave total returns of 25%. The cable companies lagged somewhat with Rogers Communications (also an IWB pick) only returning 10%.

My Income Investor pick, Shaw Communications (TSX: SJR.B, NYSE: SJR), finishing the year flat, after taking dividends into account. Shaw’s first quarter 2012 numbers to Nov. 30, 2011 were reasonable, although it is losing basic cable subscribers to Telus’ Internet TV offering. Despite that, management felt confident enough to raise the dividend by $0.05 (7%) to $0.97 annually, giving a yield of 4.6% based on the Jan. 20 closing price of $19.95.

Action now: Buy. Shaw underperformed industry peers in 2011 and the dividend increase makes the stock more attractive.

REITs did well, with the return from the iShares S&P/TSX Capped REIT ETF (TSX: XRE) totaling 18%. My REIT selections saw varied performance. Canada’s largest apartment landlord, Boardwalk REIT (TSX: BEI.UN, OTC: BOWFF) was up 28%; multi-sector play Canadian REIT (TSX: REF.UN, OTC: CRXIF) was ahead 20%; and retail centre operator Primaris (TSX: PMZ.UN, OTC: PMZFF) added 10.5%, all after taking their distributions into account.

It is worthwhile pointing out that the capital returns this year and last comprise essentially all of the gains investors have made from this sector over the last five years. The five-year compound annual price returns for these three REITs are all in the 1.5% to 4.5% range and XRE’s price actually fell 0.7% annually over the same period. This reflects the fact that property investments like REITs use a fair amount of leverage to maximize returns from their portfolios, which makes them vulnerable when interest rates are rising, as was the case between 2006 and 2008. Conversely, they benefit from falling and low rates, such as we have enjoyed for the last three years. With the Bank of Canada signaling that interest rates are more likely to fall than rise this year from their present level of 1% and the Federal Reserve having essentially promised to leave U.S. rates at 0.25% until mid 2013, REITs, utilities, and pipelines should all enjoy another year of good relative returns.

Action now: All three REITs are Buys for stability and gradually rising distributions.

The other above-average performers among my recommendations fell into two groups. One group enjoyed strong operating performances and raised their dividends. These included CN Rail (TSX: CNR, NYSE: CNI), property and casualty insurer Intact Financial (TSX: IFC, OTC: IFCZF), and cinema operator Cineplex (TSX: CGX, OTC: CPXGF). All produced total returns of 17% to 18% in 2011.

Action now: All three are Holds due to the slower economy. There are also some industry-specific issues in each case. Cineplex has been hurt by an unusually weak film season, Intact has pricing issues and a high level of weather-related claims, and the slowdown in the economy suggests a probable flattening in volumes for CN.

The second group was comprised of securities in the more stable, defensive sectors such as consumer products and medicine. These included global beverage alcohol company Diageo plc (NYSE: DEO), pharmaceutical and consumer products maker Johnson & Johnson (NYSE: JNJ), and Alberta liquor distributor Liquor Stores (TSX: LIQ, OTC: LQSIF). They produced total returns of 12%, 8%, and 6% last year.

Perhaps the distinguishing feature here is the comfort that investors evidently drew from seeing companies that were able to benefit even from the restrained growth that the Canadian and U.S. economies delivered last year. Also, in the case of the multi-nationals, they had sufficient geographical diversity to enjoy decent overall growth even when the demand for their products in developed markets was fairly static.

Action now: Diageo and J&J are Buys, due to their stability and gradually rising dividends. Liquor Stores is a Hold due to slowing same-store sales.

Finally there was a group of stocks that had slightly negative total returns but still managed to outperform the TSX. These included restaurant chain The Keg (TSX: KEG.UN, OTC: KRIUF) which lost -0.5%; Bank of Nova Scotia (TSX, NYSE: BNS) and Canadian Oil Sands (TSX: COS, OTC: COSWF), both of which were down 5%; and garbage collector Progressive Waste Solutions (TSX, NYSE: BIN) which gave back 7%.

While steakhouse chain The Keg did much better than its more expensive rivals as consumers were economizing, its same-store sales numbers were flat to down a little. Scotiabank continued to build up its Latin American and Asian operations with acquisitions in Colombia and further investments in China, but the margin squeeze caused by low interest rates saw investors generally cautious on the banking sector. It should be noted that a reliable way to outperform the bank sector has been to buy the worst performing bank, which last year was Scotiabank, and it did raise its dividend for the first time since 2008.

Meanwhile Canadian Oil Sands’ reduction of its payout at the end of 2010 was not completely offset by an increase in 2011. However, foreign strategic investors continued to find the oil sands attractive, with PetroChina buying out the 40% minority stake in its joint venture at Fort Mackay in December.

Lastly, Progressive’s series of tuck-in acquisitions of smaller garbage firms was countered by continued weakness in U.S. builders’ waste and tough pricing competition in the U.S. North East. Garbage however, remains one of the few sectors with pricing power, as collection rates continue to rise helped by the difficulty of obtaining permits for new landfills.

Action now: If you are concerned about the economic slowdown, sell The Keg and Progressive Waste as they are more economically sensitive than most of the other picks. Otherwise, Hold. Scotiabank is a Buy for the same reasons as Shaw: it has underperformed its peers and the dividend is moving higher. I also suggest buying Canadian Oil Sands. Natural gas prices remain low while oil prices are high, which helps the company’s margins.

In the next issue, I’ll look at those stocks which did worse than the index.

Gavin Graham is President of Graham Investment Strategy and is a popular guest on radio and television business shows.

 

JANUARY’S TOP PICKS

Here are the top picks for this month. Prices are as of the close of trading on Jan. 20 unless otherwise stated.

Canadian General Investments 4.65% Class A Series 2 Preferreds (TSX: CGI.PR.B).

Type: Cumulative, redeemable, retractable preferred shares

Symbol: CGI.PR.B

Exchange: TSX

Current price: $25.27

Entry level: Current price

Credit rating: DBRS: Pfd 1 (low)

Risk rating: Conservative

Recommended by: Tom Slee

Website: www.mmainvestments.com/index.cfm?Section=CGI&Page=CGI_Preferred

The business: Created in January 1930, Canadian General Investments (CGI) is one of the oldest closed-end investment funds in North America. Closed-end funds are similar to conventional mutual funds but have a fixed number of shares outstanding. Canadian General is part of the Morgan Meighen Group.

Dedicated to more senior, relatively low-risk investments, CGI owns a $600 million portfolio of top-quality investments and has net assets amounting to about $450 million. Major holdings include Enbridge, Brookfield Office Properties, and Bank of Montreal. The well-diversified portfolio currently has a 10.6% weighting in cash and Canadian Treasury bills.

The security: These are cumulative preferred shares so that in the extremely unlikely event a quarterly dividend is omitted or partially paid, the shortfall becomes a corporate liability and is owed to the shareholder. The company can redeem the shares at any time at a price of $25.50 before March 15, 2012, then at $25.25 until March 15, 2013, and at $25 thereafter. Investors can redeem their shares for $25 each in cash on and after March 15, 2014.

Why we like it: This is a high-quality preferred share with one of Dominion Bond Rating Service’s highest ratings. That means the principal and dividends are supported by strong earnings and a superior balance sheet. To give you some perspective, Pdf 1 is equivalent to an AAA senior bond rating.

At the current price of $25.27 theses shares yield 4.59%. If you choose to cash in on March 15, 2014, the yield to retraction is 3.67% at a time when two-year GICs are paying about 1.50%.

Financial highlights: CGI had a net asset value per common share of $21.61 as of Jan. 20. Total cash dividends of $0.80 per common share were paid by Canadian General Investments in 2011 representing a 5% yield based on a December 2011 market price of $15.87.

Risks: It is possible that Canadian General Investment may be unable to pay its preferred dividends but this is very unlikely. The company cannot declare its all-important common dividends until the preferred shareholders have been paid. There is an outside chance that the shares will be redeemed prior to March 15, 2014 but any resulting capital loss would be minimal.

Distribution policy: Dividends of $0.29 per preferred share will be paid on each March 15, June 15, Sept. 15 and Dec. 15 for a total of $1.1625 per annum.

Tax implications: Dividends are taxable income in the year received and eligible for the dividend tax credit when held in a non-registered account. Any profit or loss from a sale, redemption, or retraction is treated as a capital gain or loss at the time.

Who it’s for: These shares are suitable for conservative investors seeking reliable income and a specific term at their option.

Action now: The Canadian General Investment Class A, Series 2, are a Buy at $25.27 but do not chase them up and expose yourself to a much lower yield and a possible loss if the issue is called for redemption. – T.S.

Pure Industrial Real Estate Trust (TSX-V: AAR.UN).

Type: Real estate investment trust

Trading symbol: AAR.UN

Exchange: TSX Venture

Current price: $4.60

Entry level: Current price

Risk Rating: Higher risk

Recommended by: Gordon Pape

Website: www.piret.ca

The business: Pure Industrial (PIRET) is based in Vancouver and bills itself as “Canada’s only pure-play industrial REIT”. Its mandate is to “acquire, own and operate a diversified portfolio of income producing industrial properties in primary industrial markets” across the country. The long-term objectives are to generate stable and growing cash distributions, to maximize the long-term value of its properties through active management, and to grow in size and increase distributable income through accretive acquisitions.

The security: I am recommending the trust units of PIRET which trade on the Toronto Venture Exchange.

Why we like it: PIRET came to my attention as a result of a stock screen published in The Globe and Mail that identified Canadian and U.S. REITs that are financially strong and are in a good position to maintain and perhaps raise their payouts. Because PIRET trades on the Toronto Venture Exchange it is not on the radar screens of most analysts. As a result, few people have heard of it despite its good yield.

As of the end of the third quarter (Sept. 30/11) the REIT held a portfolio of 62 investment properties valued at $424.3 million. That was more than double the portfolio size at the end of the 2010 fiscal year, when it stood at $205.6 million. The reason: PIRET acquired 29 new properties during the period. Outstanding mortgages against the properties totalled $246.2 million and the loan to gross book value was 57.4%. The occupancy rate was 99%. The trust focuses its investments in Alberta, the Greater Toronto area, and the lower mainland of British Columbia.

Financial highlights: Revenues are growing rapidly. For the first nine months of 2011, the trust took in $22.7 million compared to $9.8 million in the same period of 2010. Funds from operations (FFO) for the period increased to $11.4 million from $4.1 million the previous year but on a per unit basis the improvement was only $0.02 ($0.26 from $0.24). Overall, the REIT reported a net loss of $4.4 million for the nine months.

Risks: An economic slowdown could potentially hurt the REIT if any of its tenants were forced to default on rent. Higher interest rates would also have a negative impact on earnings.

Distribution policy: Distributable income for the first nine months was $11.3 million ($0.25 per unit). Payments to unitholders were $0.23 per unit for a payout ratio of 91.6%. The trust pays out $0.025 per month ($0.30 a year) which translates to a yield of 6.5% based on the Jan. 20 closing price of $4.60. That’s on the high side for a REIT (Boardwalk’s current yield is 3.4%), reflecting the relatively small size of PIRET and its listing on the Venture Exchange.

Tax implications: This REIT offers significant tax advantages if the units are held in a non-registered account. A portion of the payment is received in the form of tax-deferred return of capital (ROC). The tax breakdown for 2011 is not yet available but in 2010 the entire distribution was treated as ROC for tax purposes.

Who it’s for: This REIT is suitable for investors who want above-average yield and who are willing to accept more risk than is normally associated with mainstream REITs.

How to buy: The units trade actively on the Venture Exchange and recent volume has generally exceeded 100,000 shares per day. There is no U.S. listing.

Summing up: Overall, PIRET looks like a good choice for an investor who is willing to accept a higher degree of risk. The balance sheet is sound and the trust is generating adequate cash flow to maintain its distribution although any increase seems unlikely in the near future.

Action now: PIRET is a Buy for aggressive investors. – G.P.

 

UPDATES

H&R REIT 5.9% Convertible Debentures (TSX: HR.DB.D)

Type: Convertible, subordinated debentures

Trading symbol: HR.DB.D

Exchange: TSX

Current price: $109.78

Originally recommended: Nov. 24/10 at $103

Risk Rating: Moderate risk

Recommended by: Tom Slee

Website: www.hr-reit.com

Comments: H&R REIT reported solid third-quarter earnings. Adjusted free cash flow of $63 million, equal to $0.39 a unit, was up 5.4% from the year before while cash from operations was $104 million against $83 million in 2010. As a result, the trust is now expected to report an adjusted free cash flow of about $1.50 per unit in 2012 and $1.60 next year. We should see an annual distribution of $1.25 in 2013.

At the same time there is continued expansion and management announced the acquisition of the modern Hess Building in Houston for US$442.5 million. This is a company on the move.

We therefore continue to like the H&R REIT 5.9% convertible debentures which are due to mature on June 30, 2020. They are currently trading at $109.78 to yield 4.7% to maturity. They are convertible at any time into units of H&R REIT at $23.50. In other words you receive 42.55 units for every $1,000 debenture. So at $109.78 you are paying $25.80 for the units now priced at $23.45, a reasonable 10% premium. One caveat: the trust can call the debentures at a price of $1,000 on and after July 1, 2016 but in that event you could convert into the units which I expect to have grown in value.

Action now: The H&R REIT 5.9% convertible debentures are a Buy at $109.78 for income and growth. – T.S.

 

CORRECTION

In the Update Edition of Jan. 4, we gave the wrong code for the RBC Canadian Equity Income Fund. The correct code is RBF591. We apologize for any inconvenience. – G.P.

 

That’s it for this issue. Watch for your next Update Edition during the week of Feb. 6. The next regular issue will be published on Feb. 22.

 

Best regards,

Gordon Pape, editor-in-chief

In this issue:

BEATING THE TRUST TAX

By Gordon Pape, Editor and Publisher

The trust market in Canada was decimated by the introduction of the SIFT tax, which came into effect on Jan. 1 last year. But it is not dead yet. The REIT sector was largely unaffected by the tax, a few trusts have moved offshore, and some of the old ones chose not to convert to corporations.

Especially interesting has been the creation of some new trusts which have been structured in such a way as to avoid the new tax. Whether Ottawa will tolerate them for long is problematic, especially if the industry gets too aggressive and tries to rebuild the sector by taking advantage of a loophole in the SIFT rules. (SIFT is the acronym for specified investment flow-through, which covers most income trusts and limited partnerships in Canada.)

So are these new tax-busting trusts worth considering? I analyzed two of them and here’s the story.

Eagle Energy Trust (TSX: EGL.UN). Eagle avoids the SIFT tax by listing its units in Canada but holding only U.S.-based assets. Management’s strategy is to focus on producing properties – the trust will not engage in extensive exploration activities. The current focus is on the old Salt Flat Field in south central Texas, which was originally discovered in 1928. Eagle is using conventional horizontal drilling techniques to tap into previously unexploited reserves.

This is still a fledgling operation. As of the end of 2011, Eagle was producing only 2,425 barrels of oil per day (bbls/d), all of which is light sweet crude. Target for this year is an average of 2,600 bbls/d. Management estimates there are adequate reserves to maintain the current operation and level of distribution for three years. It’s not clear at this point what will happen after that. Management is only saying that it is seeking to acquire other producing properties in the U.S.

Distributions are being paid at the rate of $0.0875 per unit each month ($1.05 per year). In a guidance statement issued on Dec. 5, management said that it expects funds from operations of $40 million in 2012, assuming an average price of US$88 per barrel. If this turns out to be accurate, the payout ratio would be 50%.

The market isn’t so sure about that and is pricing a high degree of risk into Eagle. The units closed on Jan. 20 at $10.34 for a projected yield of 10.2%, if the distributions are sustained. That’s an attractive payout and some of the money will be received as tax-deferred return of capital in non-registered accounts. But the size of the company and the short-term viability of its current operation make this a high-risk play.

Parallel Energy Trust (TSX: PLT.UN). This is another new trust (prospectus filed in March 2011) which has been structured to avoid the SIFT tax in the same way as Eagle. Parallel’s initial investment is in a natural gas and gas liquids property located in the West Panhandle Field in Texas. It is part of the Hugoton gas field, the largest conventional gas field in North America.

The trust completed an initial public offering worth $393.3 million gross in early May, issuing 39.33 million shares at $10. The proceeds were used to purchase a stake in a West Panhandle property. Parallel owns 59% of Bravo Natural Gas LLC’s Panhandle asset, which is located in the Carson, Hutchinson, Moore, and Potter counties of Northern Texas. The Panhandle acreage consists of approximately 290 producing wells. The company says it also offers exploitation and development opportunities.

The share price touched $11 in mid-May and then went in to a prolonged decline, bottoming out at $6.80 in mid-December. It has since rallied back to close on Jan. 20 at $8.26.

Given its brief history, we don’t have a lot of information available to enable us to judge Parallel’s long-term potential. Third-quarter production averaged 3,662 barrels of oil equivalent per day (boe/d), most of which was in the form of natural gas and natural gas liquids.

The trust reported revenue net of royalties of $13.4 million for the quarter. Funds from operations came in at $9.1 million and the trust reported net income of about $5.8 million.

In late November, management announced that the trust has established a capital expenditure budget of US$16.5 million for 2012 and set a production target of between 4,600 and 4,800 boe/d for the year. Of that, 1,600 boe/d has been committed under hedging agreements which set a floor price of US$4.20 per mmbtu for natural gas, US$54 a barrel for natural gas liquids, and US$92.50 a barrel for oil.

The trust currently pays monthly distributions of $0.075 per unit ($0.90 a year). At a price of $8.26, that projects to a yield of 10.9% over the next 12 months. In a recent research report, associate analyst Jennifer Dowdell of RBC Capital Markets said she estimates that will amount to a payout ratio of 112% in 2012 which is high but “manageable”.

Personally, I distrust payout ratios that are higher than 95%, especially in the case of new entities such as this. The market obviously is thinking along the same lines, which is why the units are priced to produce such a high cash return.

Like Eagle, Parallel offers high cash flow and the potential for price appreciation but the risks are much higher than for well-established companies such as ARC Resources and Canadian Oil Sands. Therefore only investors who are willing to accept a higher degree of risk should consider these newcomers.

Please note that these are not formal Income Investor recommendations as both are too risky for our normal parameters. Therefore we will not be tracking performance on an on-going basis.

Gordon Pape’s new book, Retirement’s Harsh New Realities, can be purchased through our on-line Best Books store, which is associated with Amazon: http://astore.amazon.ca/buildicaquizm-20. It is also available in e-book formats for Kindle, Kobo, and other readers.

Follow Gordon Pape’s latest updates on Twitter: http://twitter.com/GPUpdates

 

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A LOOK AT RETRACTABLE PREFERREDS

By Tom Slee, Contributing Editor

There are plenty of variables and unknowns as we go into the New Year but one thing seems certain: The central banks are going to keep a stranglehold on interest rates. They have no choice. Economic activity here and in Europe is actually slowing in what was to be the third full year of recovery. For instance, we are looking at Canadian GDP growth of about 1.8%, down from 2.3% in 2011 – and that is one of the brighter spots.

So bond markets are likely to move sideways for the foreseeable future. As a matter of fact, the U.S. Federal Reserve is committed to exceptionally low rates until at least the middle of 2013. On Jan. 9, Germany’s Federal Finance Agency issued six-month Treasury bonds with a minus 0.12% yield. That’s right, a negative 0.12%. People are paying the government to look after their money!

It’s a sombre outlook as far as fixed-income investors are concerned, especially while North American stocks remain a question mark. It also means that we will have to look for opportunities outside the mainstream markets in order to boost our returns. REITs, preferred shares, and some of the remaining income trusts are more likely to provide attractive situations than conventional bonds. Even now blue-chip Canadian straight preferred shares are yielding 200 basis points more than comparable corporate debentures. Moreover, preferreds come with all sorts of bells and whistles so you can choose one that suits your requirements.

To give you an example, the mostly overlooked retractable preferred shares provide what is essentially a maturity date. You have the option of selecting the term and cashing in at a predetermined price. Here is some background.

Preferred shares have never been fashionable for several reasons. First, they are hybrids, in effect equity with a fixed dividend and no earnings participation – call them quasi bonds, if you like.

Second, there are relatively few of them because corporations normally finance their operations with bonds and stocks. As a result, preferred share trading is fairly thin. So brokers and advisors focus on stocks or, more likely these days, mutual funds.

Third, and perhaps most important, over the years there has been little spread between preferred share and bond yields. As a result, small fixed-income investors and institutions have tended to favour bonds with their guaranteed principal repayment, greater liquidity, and broad choice.

These days, though, we have an unusual situation. Canadian and U.S. bond markets are essentially capped with yields near record lows right across the spectrum. As I write, two-year Government of Canada bonds are yielding 1%, with inflation running at 2.3%. That represents a negative return even before taxes. At the other end of the curve, 10-year corporate debentures are paying 3.25%. By comparison, the Canadian Utilities Straight Preferred Shares Series W, is priced at $25.80 and yields 5.6%, which is 235 basis points more.

Of course, bonds and preferred shares are not strictly comparable. Bonds have a maturity date with a guaranteed repayment of the par value in full. Straight preferreds are perpetual, in other words open-ended, and you have to sell them into the market in order to recover your capital. There are, however, some issues that carry a retractable provision. The investor can redeem the shares on a predetermined date for a specific value. These shares have what amounts to a maturity date. Some investors may find this feature attractive.

A word of caution, however, about retractable preferreds: Read the small print carefully. These issues are divided into two categories. “Soft” retractables allow the company to pay an investor in cash or common shares when called, which to some extent turns the shares into convertibles. In fact, they trade that way. To give you an example, the Brookfield Properties Series H Preferred Shares are retractable at $25.60 and yield a relatively high 5.6%. That is because the company can pay investors with common shares when they exercise the retraction feature on or after Dec. 31, 2015. As you can see there is a stock market element built into the current price.

The “hard” retractable shares, a much smaller category, are clearer cut and give an investor the right to sell the shares for cash. They are similar to bonds and as a result yield less than “soft” issues in the present environment.

My suggestion is that readers who want a fixed-term investment should opt for “hard” preferred shares. One issue that I like right now is the Canadian General Investments Class A, Series 2. It’s my January Top Pick and you’ll find all the details elsewhere in this issue.

Canadian Bond Investors Association

Turning to another front entirely, I was very pleased to see the recent formation of a Canadian Bond Investors Association. This is very good news for small fixed-income investors. Normally I am not a fan of committees and commissions but bondholders in this country have been treated as second-class citizens for far too long. We need a voice. In theory we are senior to shareholders in the investment world and supposedly our rights are fully protected. However, as we saw during the infamous BCE buyout negotiations in 2008, that is not how our courts see things. The new Association is a first move to put things right.

As you may recall, almost four years ago the Ontario Teachers’ Pension Plan launched a leveraged buyout bid for BCE. The offer of $42.75 a share was 40% above market, a $10 billion bonanza for the common shareholders.

Later, Teachers agreed to take out the preferred shareholders at a premium. But there was one snag. The deal saddled BCE with $34 billion in additional debt which, in effect, reduced all of the company’s outstanding bonds to junk status. As a matter of fact, the existing bondholders, who had not been consulted, saw the value of their supposedly top-quality investments plummet. After their protests were ignored they launched a lawsuit against BCE but lost. The Supreme Court of Canada ruled that boards of directors are required to maximize shareholder profit, even if bondholders are hurt.

Institutional money managers have stewed over that decision ever since. Now they are going to do something about it by combining their purchasing power to exert influence on the bond issuers. They want safeguards against risks created by corporate restructuring. In future, bondholders should have the right to participate in any privatization and even voting rights under certain circumstances. Perhaps most important, the major bond buyers want a say in an underwriter’s terms and conditions. As one leading bond manager pointed out: “When a new issue comes you get 20 minutes notice to get your order in.” There is no discussion of covenants and indentures. That has to change.

The new association also plans to apply pressure on the banks. They have been issuing increasingly arcane fixed-income securities in order to beef up their T1 capital, sometimes exposing investors to poorly explained risks in the process. For example, the new non-viable contingent capital bonds convert to equity when a bank’s T1 capital falls below a certain level and presumably the bank is in serious trouble. If that happens, the conversion feature is possibly worthless and is certainly devalued. Arguably the banks are not warning the public about this threat.

Another problem on the association’s agenda is a protest about the bill now before Parliament that would place pensioners ahead of bondholders in a corporate bankruptcy. This could be the start of a slippery slope that would eventually reduce bondholders to unsecured creditors competing with trade payables. There is a lot to do and it would be good to see more clarity and protection in what is an almost unregulated bond market. We would all benefit.

Tom Slee managed millions of dollars in pension money for many years and is an expert in fixed-income securities.

 

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GAVIN GRAHAM REVISITS PAST PICKS

By Gavin Graham, Contributing Editor

The start of a New Year is always the traditional time to review the performance of past selections. Let’s begin by looking at how my recommendations performed in 2011 and whether there are any underlying themes that emerge that may be helpful for this year.

This review will be in two parts. In this issue, we’ll examine those picks that outperformed the S&P/TSX Composite’s -9% return for the twelve months to Jan. 13th, 2012 (-7% after taking dividends into account). Then we’ll look at those that underperformed the index in the February issue.

Last year ranked amongst the worst years for equity returns in the last decade, surpassed to the downside only by 2008 and 2001-02. Investors’ optimism at the beginning of 2011 translated into a rise in the markets through April, at which point the indexes had doubled since their lows in March 2009.

But during the summer it became apparent that the debt crisis in the eurozone had not been successfully addressed by the initial bail-out package in May 2010. That crisis combined with the budget standoff in the Washington, which contributed to the U.S. losing its AAA rating in August, shook investor confidence to the core. Stocks plummeted through the third quarter, resulting in a full-fledged bear market with indexes down 20% from their highs.

Some positive actions by the European authorities finally restored a measure of confidence, which was reinforced by improved growth in the U.S. and the first declines in interest rates and reserve requirements in emerging markets. That sparked a rebound in the fourth quarter. The Dow Jones Industrials Average, which is comprised of blue-chip companies with good balance sheets, was the only developed market index rise during the year, gaining 8%. The S&P 500 Index in the U.S. was flat. Every other major developed and emerging index was down between 5% and 25%.

Government bond markets outside of the eurozone were the beneficiaries. Investors looking for perceived “safety” were willing to lend their hard earned capital to governments with enormous budget deficits and challenging demographics for up to 10 years for less than 2%. In the case of Japan, the country with the biggest deficit and the worst demographics, the return was less than 1%! The one investment certainty over the next decade is that these investors will suffer a real after-inflation loss of their principal.

This approach seems particularly unattractive when compared to the higher nominal yields available on good quality equities of varying market capitalization. Plus, they enjoy the benefit of being able to at least keep up with inflation by raising their dividends. Let’s examine some of these stocks now.

The recommendations that did best last year were principally those which benefited from the low interest rate environment while providing a stable and possibly growing yield, namely utilities, pipelines, and REITs. This will not be any surprise to Income Investor readers but it’s remarkable just how well these sectors performed compared to the more economically sensitive areas of energy, materials, and industrials.

My best performing recommendation was Alberta pipeline and energy company AltaGas (TSX: ALA, OTC: ATGFF). It produced a total return of 39% including a 5% yield as improvements to its pipeline network were complemented by some of its renewable energy projects beginning construction or coming on stream.

Other contributors’ Income Investor pipeline recommendations such as Enbridge (TSX, NYSE: ENB) and TransCanada Corp. (TSX: NYSE: TRP) produced 33% and 18% total returns respectively. This proved that regardless of potential political delays to new pipeline projects such as Keystone XL and Northern Gateway, the regulated utility model remains attractive.

Action now: I said last summer that AltaGas could be a sell due to its strong performance. That is still the case. If investors are concerned about the outlook for the economy and markets then it would make sense to take some profits here. Otherwise, AltaGas remains a Hold.

The telecom stocks were also strong performers. Telus and BCE (both recommendations of our companion Internet Wealth Builder newsletter) gave total returns of 25%. The cable companies lagged somewhat with Rogers Communications (also an IWB pick) only returning 10%.

My Income Investor pick, Shaw Communications (TSX: SJR.B, NYSE: SJR), finishing the year flat, after taking dividends into account. Shaw’s first quarter 2012 numbers to Nov. 30, 2011 were reasonable, although it is losing basic cable subscribers to Telus’ Internet TV offering. Despite that, management felt confident enough to raise the dividend by $0.05 (7%) to $0.97 annually, giving a yield of 4.6% based on the Jan. 20 closing price of $19.95.

Action now: Buy. Shaw underperformed industry peers in 2011 and the dividend increase makes the stock more attractive.

REITs did well, with the return from the iShares S&P/TSX Capped REIT ETF (TSX: XRE) totaling 18%. My REIT selections saw varied performance. Canada’s largest apartment landlord, Boardwalk REIT (TSX: BEI.UN, OTC: BOWFF) was up 28%; multi-sector play Canadian REIT (TSX: REF.UN, OTC: CRXIF) was ahead 20%; and retail centre operator Primaris (TSX: PMZ.UN, OTC: PMZFF) added 10.5%, all after taking their distributions into account.

It is worthwhile pointing out that the capital returns this year and last comprise essentially all of the gains investors have made from this sector over the last five years. The five-year compound annual price returns for these three REITs are all in the 1.5% to 4.5% range and XRE’s price actually fell 0.7% annually over the same period. This reflects the fact that property investments like REITs use a fair amount of leverage to maximize returns from their portfolios, which makes them vulnerable when interest rates are rising, as was the case between 2006 and 2008. Conversely, they benefit from falling and low rates, such as we have enjoyed for the last three years. With the Bank of Canada signaling that interest rates are more likely to fall than rise this year from their present level of 1% and the Federal Reserve having essentially promised to leave U.S. rates at 0.25% until mid 2013, REITs, utilities, and pipelines should all enjoy another year of good relative returns.

Action now: All three REITs are Buys for stability and gradually rising distributions.

The other above-average performers among my recommendations fell into two groups. One group enjoyed strong operating performances and raised their dividends. These included CN Rail (TSX: CNR, NYSE: CNI), property and casualty insurer Intact Financial (TSX: IFC, OTC: IFCZF), and cinema operator Cineplex (TSX: CGX, OTC: CPXGF). All produced total returns of 17% to 18% in 2011.

Action now: All three are Holds due to the slower economy. There are also some industry-specific issues in each case. Cineplex has been hurt by an unusually weak film season, Intact has pricing issues and a high level of weather-related claims, and the slowdown in the economy suggests a probable flattening in volumes for CN.

The second group was comprised of securities in the more stable, defensive sectors such as consumer products and medicine. These included global beverage alcohol company Diageo plc (NYSE: DEO), pharmaceutical and consumer products maker Johnson & Johnson (NYSE: JNJ), and Alberta liquor distributor Liquor Stores (TSX: LIQ, OTC: LQSIF). They produced total returns of 12%, 8%, and 6% last year.

Perhaps the distinguishing feature here is the comfort that investors evidently drew from seeing companies that were able to benefit even from the restrained growth that the Canadian and U.S. economies delivered last year. Also, in the case of the multi-nationals, they had sufficient geographical diversity to enjoy decent overall growth even when the demand for their products in developed markets was fairly static.

Action now: Diageo and J&J are Buys, due to their stability and gradually rising dividends. Liquor Stores is a Hold due to slowing same-store sales.

Finally there was a group of stocks that had slightly negative total returns but still managed to outperform the TSX. These included restaurant chain The Keg (TSX: KEG.UN, OTC: KRIUF) which lost -0.5%; Bank of Nova Scotia (TSX, NYSE: BNS) and Canadian Oil Sands (TSX: COS, OTC: COSWF), both of which were down 5%; and garbage collector Progressive Waste Solutions (TSX, NYSE: BIN) which gave back 7%.

While steakhouse chain The Keg did much better than its more expensive rivals as consumers were economizing, its same-store sales numbers were flat to down a little. Scotiabank continued to build up its Latin American and Asian operations with acquisitions in Colombia and further investments in China, but the margin squeeze caused by low interest rates saw investors generally cautious on the banking sector. It should be noted that a reliable way to outperform the bank sector has been to buy the worst performing bank, which last year was Scotiabank, and it did raise its dividend for the first time since 2008.

Meanwhile Canadian Oil Sands’ reduction of its payout at the end of 2010 was not completely offset by an increase in 2011. However, foreign strategic investors continued to find the oil sands attractive, with PetroChina buying out the 40% minority stake in its joint venture at Fort Mackay in December.

Lastly, Progressive’s series of tuck-in acquisitions of smaller garbage firms was countered by continued weakness in U.S. builders’ waste and tough pricing competition in the U.S. North East. Garbage however, remains one of the few sectors with pricing power, as collection rates continue to rise helped by the difficulty of obtaining permits for new landfills.

Action now: If you are concerned about the economic slowdown, sell The Keg and Progressive Waste as they are more economically sensitive than most of the other picks. Otherwise, Hold. Scotiabank is a Buy for the same reasons as Shaw: it has underperformed its peers and the dividend is moving higher. I also suggest buying Canadian Oil Sands. Natural gas prices remain low while oil prices are high, which helps the company’s margins.

In the next issue, I’ll look at those stocks which did worse than the index.

Gavin Graham is President of Graham Investment Strategy and is a popular guest on radio and television business shows.

 

JANUARY’S TOP PICKS

Here are the top picks for this month. Prices are as of the close of trading on Jan. 20 unless otherwise stated.

Canadian General Investments 4.65% Class A Series 2 Preferreds (TSX: CGI.PR.B).

Type: Cumulative, redeemable, retractable preferred shares

Symbol: CGI.PR.B

Exchange: TSX

Current price: $25.27

Entry level: Current price

Credit rating: DBRS: Pfd 1 (low)

Risk rating: Conservative

Recommended by: Tom Slee

Website: www.mmainvestments.com/index.cfm?Section=CGI&Page=CGI_Preferred

The business: Created in January 1930, Canadian General Investments (CGI) is one of the oldest closed-end investment funds in North America. Closed-end funds are similar to conventional mutual funds but have a fixed number of shares outstanding. Canadian General is part of the Morgan Meighen Group.

Dedicated to more senior, relatively low-risk investments, CGI owns a $600 million portfolio of top-quality investments and has net assets amounting to about $450 million. Major holdings include Enbridge, Brookfield Office Properties, and Bank of Montreal. The well-diversified portfolio currently has a 10.6% weighting in cash and Canadian Treasury bills.

The security: These are cumulative preferred shares so that in the extremely unlikely event a quarterly dividend is omitted or partially paid, the shortfall becomes a corporate liability and is owed to the shareholder. The company can redeem the shares at any time at a price of $25.50 before March 15, 2012, then at $25.25 until March 15, 2013, and at $25 thereafter. Investors can redeem their shares for $25 each in cash on and after March 15, 2014.

Why we like it: This is a high-quality preferred share with one of Dominion Bond Rating Service’s highest ratings. That means the principal and dividends are supported by strong earnings and a superior balance sheet. To give you some perspective, Pdf 1 is equivalent to an AAA senior bond rating.

At the current price of $25.27 theses shares yield 4.59%. If you choose to cash in on March 15, 2014, the yield to retraction is 3.67% at a time when two-year GICs are paying about 1.50%.

Financial highlights: CGI had a net asset value per common share of $21.61 as of Jan. 20. Total cash dividends of $0.80 per common share were paid by Canadian General Investments in 2011 representing a 5% yield based on a December 2011 market price of $15.87.

Risks: It is possible that Canadian General Investment may be unable to pay its preferred dividends but this is very unlikely. The company cannot declare its all-important common dividends until the preferred shareholders have been paid. There is an outside chance that the shares will be redeemed prior to March 15, 2014 but any resulting capital loss would be minimal.

Distribution policy: Dividends of $0.29 per preferred share will be paid on each March 15, June 15, Sept. 15 and Dec. 15 for a total of $1.1625 per annum.

Tax implications: Dividends are taxable income in the year received and eligible for the dividend tax credit when held in a non-registered account. Any profit or loss from a sale, redemption, or retraction is treated as a capital gain or loss at the time.

Who it’s for: These shares are suitable for conservative investors seeking reliable income and a specific term at their option.

Action now: The Canadian General Investment Class A, Series 2, are a Buy at $25.27 but do not chase them up and expose yourself to a much lower yield and a possible loss if the issue is called for redemption. – T.S.

Pure Industrial Real Estate Trust (TSX-V: AAR.UN).

Type: Real estate investment trust

Trading symbol: AAR.UN

Exchange: TSX Venture

Current price: $4.60

Entry level: Current price

Risk Rating: Higher risk

Recommended by: Gordon Pape

Website: www.piret.ca

The business: Pure Industrial (PIRET) is based in Vancouver and bills itself as “Canada’s only pure-play industrial REIT”. Its mandate is to “acquire, own and operate a diversified portfolio of income producing industrial properties in primary industrial markets” across the country. The long-term objectives are to generate stable and growing cash distributions, to maximize the long-term value of its properties through active management, and to grow in size and increase distributable income through accretive acquisitions.

The security: I am recommending the trust units of PIRET which trade on the Toronto Venture Exchange.

Why we like it: PIRET came to my attention as a result of a stock screen published in The Globe and Mail that identified Canadian and U.S. REITs that are financially strong and are in a good position to maintain and perhaps raise their payouts. Because PIRET trades on the Toronto Venture Exchange it is not on the radar screens of most analysts. As a result, few people have heard of it despite its good yield.

As of the end of the third quarter (Sept. 30/11) the REIT held a portfolio of 62 investment properties valued at $424.3 million. That was more than double the portfolio size at the end of the 2010 fiscal year, when it stood at $205.6 million. The reason: PIRET acquired 29 new properties during the period. Outstanding mortgages against the properties totalled $246.2 million and the loan to gross book value was 57.4%. The occupancy rate was 99%. The trust focuses its investments in Alberta, the Greater Toronto area, and the lower mainland of British Columbia.

Financial highlights: Revenues are growing rapidly. For the first nine months of 2011, the trust took in $22.7 million compared to $9.8 million in the same period of 2010. Funds from operations (FFO) for the period increased to $11.4 million from $4.1 million the previous year but on a per unit basis the improvement was only $0.02 ($0.26 from $0.24). Overall, the REIT reported a net loss of $4.4 million for the nine months.

Risks: An economic slowdown could potentially hurt the REIT if any of its tenants were forced to default on rent. Higher interest rates would also have a negative impact on earnings.

Distribution policy: Distributable income for the first nine months was $11.3 million ($0.25 per unit). Payments to unitholders were $0.23 per unit for a payout ratio of 91.6%. The trust pays out $0.025 per month ($0.30 a year) which translates to a yield of 6.5% based on the Jan. 20 closing price of $4.60. That’s on the high side for a REIT (Boardwalk’s current yield is 3.4%), reflecting the relatively small size of PIRET and its listing on the Venture Exchange.

Tax implications: This REIT offers significant tax advantages if the units are held in a non-registered account. A portion of the payment is received in the form of tax-deferred return of capital (ROC). The tax breakdown for 2011 is not yet available but in 2010 the entire distribution was treated as ROC for tax purposes.

Who it’s for: This REIT is suitable for investors who want above-average yield and who are willing to accept more risk than is normally associated with mainstream REITs.

How to buy: The units trade actively on the Venture Exchange and recent volume has generally exceeded 100,000 shares per day. There is no U.S. listing.

Summing up: Overall, PIRET looks like a good choice for an investor who is willing to accept a higher degree of risk. The balance sheet is sound and the trust is generating adequate cash flow to maintain its distribution although any increase seems unlikely in the near future.

Action now: PIRET is a Buy for aggressive investors. – G.P.

 

UPDATES

H&R REIT 5.9% Convertible Debentures (TSX: HR.DB.D)

Type: Convertible, subordinated debentures

Trading symbol: HR.DB.D

Exchange: TSX

Current price: $109.78

Originally recommended: Nov. 24/10 at $103

Risk Rating: Moderate risk

Recommended by: Tom Slee

Website: www.hr-reit.com

Comments: H&R REIT reported solid third-quarter earnings. Adjusted free cash flow of $63 million, equal to $0.39 a unit, was up 5.4% from the year before while cash from operations was $104 million against $83 million in 2010. As a result, the trust is now expected to report an adjusted free cash flow of about $1.50 per unit in 2012 and $1.60 next year. We should see an annual distribution of $1.25 in 2013.

At the same time there is continued expansion and management announced the acquisition of the modern Hess Building in Houston for US$442.5 million. This is a company on the move.

We therefore continue to like the H&R REIT 5.9% convertible debentures which are due to mature on June 30, 2020. They are currently trading at $109.78 to yield 4.7% to maturity. They are convertible at any time into units of H&R REIT at $23.50. In other words you receive 42.55 units for every $1,000 debenture. So at $109.78 you are paying $25.80 for the units now priced at $23.45, a reasonable 10% premium. One caveat: the trust can call the debentures at a price of $1,000 on and after July 1, 2016 but in that event you could convert into the units which I expect to have grown in value.

Action now: The H&R REIT 5.9% convertible debentures are a Buy at $109.78 for income and growth. – T.S.

 

CORRECTION

In the Update Edition of Jan. 4, we gave the wrong code for the RBC Canadian Equity Income Fund. The correct code is RBF591. We apologize for any inconvenience. – G.P.

 

That’s it for this issue. Watch for your next Update Edition during the week of Feb. 6. The next regular issue will be published on Feb. 22.

 

Best regards,

Gordon Pape, editor-in-chief