Income Securities

A recent conversation with a mutual fund manager helped me to clarify my ideas about income securities. All businesses aim to earn a profit, but only some of them return that profit to shareholders. They rise and fall in popularity, and they fit certain investment strategies better than others.

There are three categories of equity investments (shares) that can be considered income securities. Dividend-paying corporations are usually large, mature companies that pay a portion of their profits to investors. They are often “blue-chip” companies, well-respected and relatively stable. They may also run utilities or other businesses that focus on income rather than growth. REITs, or Real Estate Investment Trusts exist in many countries and are structured in a way that investors can indirectly own real estate and collect the income in a relatively tax-efficient manner. Income trusts have been a Canadian phenomenon where a business is owned by a trust. This form of indirect ownership doesn’t explicit limit liability and doesn’t attract the same tax liability as a corporation. Because taxes could be deferred under this structure, it became preferred by investors and the government responded by ending the tax advantage for Jan. 1, 2011.

Because of the tax changes affecting trusts beginning in 2011, there is some uncertainty surrounding income trusts. This should not extend to all income securities. There will be no change to dividend-paying corporations. REITs were exempted from the new (SIFT) law. Income trusts will now be taxed on their profit, then distributions to investors will be treated as an eligible dividend and taxed accordingly. The change is that the income may be lower (depending on the trust’s distribution policy), but it will be more tax efficient. For this reason, the trusts that have recently converted have unexpectedly seen an increase in unit value. Income securities seem as likely as any category of equity to be a good investment.

The investment manager had an additional idea. Because real estate and utilities represent hard assets with long-term contracts, it’s not unreasonable to apply some leverage. He is currently using 20%, with a maximum of 30% allowable. As the yield on the investments is higher than the cost of borrowing, this increases the total income produced by the portfolio. I believe it is always wise to use leverage only cautiously. In this case, keep in mind that leverage is being applied on top of companies that already run with a certain amount of debt. For example, most REITs have 50-60% loan to value in mortgages.

The popularity of investing for income seems to be rising. Baby boomers are approaching retirement, where they want to generate investment income to supplement their lifestyle. Other investors are uncertain of the economic outlook and want to get paid to wait. As demand for income securities goes up, so does the price, providing a second return to early investors.

Are income securities part of your investment strategy?