The broad-based S&P/Toronto Stock Exchange Income Trust Index (SPRTCM) has returned 114.3 percent since global stock markets bottomed in March 2009, handily beating the 85.4 percent from the S&P/Toronto Stock Exchange Composite Index (SPTSX), which includes taxable corporations. And the SPRTCM’s gain was nearly twice that of the S&P 500, which returned “only” 62.5 percent.

Thus far, 2010 has been considerably less bullish. But trusts have kept their edge, losing just 0.5 percent versus a 2.2 loss for the S&P 500 and 5 percent for the SPTSX.

“The Trust Effect” depicts the SPRTCM’s performance on a straight price-appreciation basis against the SPTSX from March 6, 2009, to February 3.

Trusts’ outperformance of almost everything else is certainly a well-kept secret. In fact, judging from the e-mail I get, a majority of investors on both sides of the border still wrongfully assume that 2011 taxation spells doomsday for all remaining income trusts, great and small.

And therein lays our opportunity for a 2010 windfall: Extreme pessimism means a very low bar of expectations, which, when hurdled, triggers considerable upside for converting companies.

In fact, all that’s really been required for post-conversion gains is for management to clarify what it will pay in 2011 and beyond. And the closer the post-conversion rate is to the current rate, the fatter the capital gains.

Aggressive Holding Ag Growth International (TSX: AFN, OTC: AGGZF), for example, is up 80.9 percent since its April 2009 announcement of a cut-less conversion. Conservative Holding Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRPFF) is up 40 percent-plus since its identical move in July.

Forecasting what trust managements will do to post-conversion dividends requires mind-reading skills I admittedly don’t have. But it is clear managements have noticed the share-price gains posted by companies that converted but did not cut.

And they’re aware those gains have reduced companies’ cost of capital, boosting their ability to finance growth far more effectively than the cash saved by a dividend cut would have.

There are limitations. As Canadian Oil Sands Trust (TSX: COS-U, OTC: COSWF) and Daylight Resources Trust (TSX: DAY-U, OTC: DAYYF) pointed out last month, their post-2010 dividends will be determined mainly by oil and natural gas prices, respectively. And the same is true for all 28 energy producers tracked in How They Rate. Trusts with high payout ratios may also have a hard time coming up with the cash to avoid cuts.

The key, however, is beating expectations. And with most managements motivated to pay as much as they can post-2010, trusts are doing that again and again, with happy results for unitholders.

They should certainly be pleased about gas-focused energy producer Trilogy Energy Trust (TSX: TET-U, OTC: TETFF). The company announced its conversion in December with a much-smaller-than-expected 30 percent dividend cut and has since outperformed the Canadian market by 10 percentage points.

I expect nothing less of Conservative Holding Innergex Power Income Fund (TSX: IEF-U, OTC: INGRF). The generator of hydroelectric (73 percent) and wind (27 percent) power cut its distribution 15 percent earlier this week as part of its conversion strategy the focus of which is a merger with manager and 16.1 percent owner Innergex Renewable Energy (TSX: INE, OTC: INGXF).

The new yield is still nearly 8.5 percent, absolutely safe from both 2011 taxation and economic pressures. In fact, the payout is set to rise as the company boosts generating capacity by nearly 40 percent over the next two years. Innergex Power is one of February’s High Yield of the Month selections, safe enough for even the most conservative of investors.

Innergex Power’s announcement leaves only Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF), Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF), CML Healthcare Income Fund (TSX: CLC-U, OTC: CMHIF), Davis + Henderson Income Fund (TSX: DHF-U, OTC: DHIFF) and IBI Income Fund (TSX: IBG-U, OTC: IBIBF) among Conservative Holdings yet to declare post-2010 intentions for their dividends.

The most important thing is all five are strong companies that will build wealth no matter how they’re taxed. And with the expectations bar set low for all of them, it’s a cinch they’ll beat it.

In the Aggressive Portfolio, Ag Growth, Newalta Corp (TSX: NAL, OTC: NWLTF) and Trinidad Drilling (TSX: TDG, OTC: TDGCF) have already converted. Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF) and Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) have declared their intention to convert in late 2010 without cutting their respective payouts.

That leaves the seven remaining oil and gas producers as the wildcards. And given the importance of energy prices to what they can pay, they haven’t gone further than stating they’ll convert by the end of 2010.

The bad news is that until they do clarify a dividend policy, the seven are likely to lag because investors will be left to fear the worst.

The good news is the global economy is slowly but surely recovering, as fourth quarter US GDP growth of 5.7 percent attests–and energy is a natural beneficiary.

By the time managements’ hands are forced, they’re likely to have a lot more cash to pay out than almost anyone expects now.

Any company whose cash flows depend on commodity prices is always at risk to dividend cuts. However, as soon-to-convert oil producer Baytex Energy Trust (TSX: BTE-U showed us last month, rising energy prices mean rising dividends, even if there are taxes to be paid.

The high potential for rising energy prices means there’s tremendous upside in these producers. That doesn’t mean, however, that we won’t be closely scrutinizing our picks’ earnings in the coming weeks. Analysis starts with results from Bell Aliant, the only CE Portfolio pick to report in time for February’s issue.

If a pick falters as a business, rest assured we’ll discard it. Otherwise, I’m looking forward to another profitable year collecting distributions and building wealth, for both Conservative and Aggressive holdings.

Below I present my usual executive summary of the rest of the issue. If you have questions about anything related to Canadian Edge, please drop us a line by clicking on the “Contact Us” item in the top-right corner of the page.

Portfolio Action

There are no changes to the CE Portfolios this month as we await fourth-quarter and full-year 2009 earnings. Note oil and gas producers will also release their reserves data, providing critical insight into their underlying value.

In this month’s Portfolio Update I highlight the 10 safest picks for yield based on my six-point CE Safety Rating System. If you’re seeking high, safe yields without commodity-price risk, this is where you should focus your buying.

My preference is to buy them in roughly equal dollar amounts, one third now, one third a month from now, the final third in two months. That way you’ll build a balanced portfolio of high-quality recommendations, with most of your shares purchased at the lowest prices.

Another way to get involved with CE picks is to buy the two High Yield of the Month picks each month until you reach your desired number of holdings.

I also discuss developments at a number of Conservative Holdings and list expected dates for the next round of earnings reports, which I’ll be analyzing extensively in the coming weeks in Flash Alerts, the weekly companion Maple Leaf Memo and in detail in the regular March and April issues of CE.

High Yield of the Month

Both February High Yield of the Month entries are Conservative Holdings this month. Innergex Power Income Fund (TSX: IEF-U, OTC: INRGF) has announced a shareholder-friendly conversion to a corporation that includes an accretive merger and relatively benign 15 percent distribution reduction. It still boasts a generous yield that’s safer than ever and is poised for growth in coming years. And it’s a potential takeover target as well. Buy Innergex Power Income Fund up to USD12.

Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF) is the first Portfolio holding to announce fourth-quarter and full-year earnings; it didn’t disappoint. The rural phone business remains one of the most reliable cash cows in North America, no matter how it’s taxed. Bell Aliant Regional Communications Income Fund is a buy up to USD27.

How They Rate

I hope you’re enjoying our new automatic updates of US dollar unit prices, dividends, yields, dividend dates and debt-to-capital ratios in How They Rate. Note that information on trust conversions is now included in a separate table within the Income Trust Tax Guide. We’ll be updating this information regularly as new conversions are announced. Information on US taxation of How They Rate companies will now be included in the table on a regular basis.

The only major changes in this issue are to CE Safety Ratings. The biggest is that “6” is now the highest rating, connoting companies that meet all six of my criteria. “0” is now the lowest rating, indicating companies that meet no safety criteria. Safety criteria–described in detail in the text below the table–are as follows:

• One point if Payout ratio meets “very safe” criteria for the sector.
• One point if Payout ratio is not “at risk” based on the criteria for its sector.
• One point if Debt/Assets ratio meets “very safe” criteria for the sector.
• One point if company is already organized as a corporation, a qualifying REIT (no change to tax status in 2011) or has clarified its dividend policy for when it converts to a corporation.
• One point if the company’s primary business is recession resistant. Qualifying varies from company to company, though virtually all Electric Power and Energy Infrastructure companies qualify, while no Energy Services companies do.
• One point if the company’s profitability is not directly affected by changes in commodity prices.

I list trusts and high yielding corporations by the following sectors:

• Oil and Gas–All producer trusts are included here.
• Electric Power–Power generators.
• Gas/Propane–A mixture of distributors, from propane to packaged ice.
• Business Trusts–A range of businesses involved principally with consumers.
• REITs–All qualified real estate investment trusts.
• Trust Mutual Funds–Closed-end funds holding portfolios of individual trusts.
• Natural Resources–Trusts and corporations that produce resources and raw materials other than oil and gas.
• Energy Services–Trusts and corporations whose main business is providing drilling, environmental or other services to energy producers.
• Energy Infrastructure–Trusts and corporations that own primarily pipelines, processing facilities and other fee-generating assets.
• Information Technology–Trusts and corporations that provide communications, newspaper, directory and other information services.
• Financial Services–Canada’s banks, investment houses and other trusts and corporations feeding that business.
• Food and Hospitality–Trusts and corporations that franchise restaurants, own and operate hotels and manufacture and distribute food and beverages.
• Health Care–Trusts and corporations involved in the medical care and/or supply business.
• Transports–Trusts and corporations that ship freight and move passengers by bus, truck, rail or air.

Here are advice changes. See How They Rate for other changes in buy targets. Price and yield information is updated every 15 minutes in both tables. Use this service as a reality check when errors occur with US quotes-based services. Note that it sometimes takes several days for a dividend cut to be updated in the live feed. All dividend cuts in our coverage universe are analyzed in detail in Dividend Watch List.

Aeroplan Group (TSX: AER, OTC: GAPFF)–Sell to Hold. Recent financing has stabilized the balance sheet, and management’s innovative marketing has attracted customers.

Bellatrix Exploration Ltd (TSX: BXE, OTC: BLLXF)–Hold to Buy @ 4. The company’s ability to raise financing last month is a major plus, as is management’s plan to expand capital spending by 88 percent in 2010 from 2009 levels. There’s no yield here, but this is a nice leveraged bet on a comeback for natural gas prices; it’s also a more reasonable takeover bet trading at book value. It’s not for the risk-averse, however.

Cenovus Energy (TSX: CVE, NYSE: CVE)–New Coverage: Buy @ 25. The oil production spinoff of EnCana Corp (TSX: ECA, NYSE: ECA) had to borrow at higher-than-expected rates to complete the needed financing for the separation. Its assets, however, are solid, and takeover appeal is great.

Contrans Group (TSX: CSS, no US symbol)–Sell to Hold. The rebound of the transportation business and resumption of at least some dividend are good signs, though TransForce (TSX: TFI, OTC: TFIFF) is a better buy in the sector.

First Quantum Minerals (TSX: FM, OTC: FQVLF)–Hold to Buy @ 80. Copper production is surging, and the company has many valuable properties possibly of interest to an acquirer. The shares are also off 20 percent from last month, when they rated a hold.

Rogers Sugar Income Fund (TSX: RSI-U, OTC: RSGUF)–Hold to Buy @ 5. The future depends on sugar prices; happily the outlook is bright for them now, and the shares yield nearly 10 percent.

Feature Article

The US is and has always been Canada’s biggest and most important trading partner. Over the past decade, however, the countries’ economic bonds with Asia have grown ever-stronger, often in spite of official government policies.

Surging Asian imports of natural resources were a big reason why Canada’s recession was so much milder and shorter-lived than the downturn in the US. But the relationship also extends to direct investment, both by Canadians in Asia and by Asians in Canada.

Here we examine the investment opportunities in all three areas, which are set to become ever-more compelling still in the coming years.

Canadian Currents

Last month, we highlighted the US Canada Tax Treaty, focusing on a little-known and widely misunderstood provision that exempts dividends paid into IRA accounts from the 15 percent Canadian withholding. Since then, we’ve heard from a range of investors and professionals on how they’re dealing with this change in the law.

CE Associate Editor David Dittman distills the key points and explores other tax issues that are important for US investors in Canada.

Note that the Income Trust Tax Guide includes information about the status of each trust regarding 2011 taxation and how its distributions should be treated in the US for tax purposes.

Tips on Trusts

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

Dividend Watch List–Only two How They Rate companies cut their payouts last month. One was High Yield of the Month selection Innergex Power Income Fund (TSX: IEF-U, OTC: INRGF), which cut a modest 15 percent as part of its planned conversion from a trust to a corporation and simultaneous merger with Innergex Renewable Energy (TSX: INE, OTC: INGXF).

The other is a trust I warned about last month, FP Newspapers Income Fund (TSX: FP-U, OTC: FPNUF). As expected, a new credit agreement places limits on how much it can pay out in distributions, mandating the 36.8 percent cut. The new rate, however, remains uncertain with 2011 taxation approaching, so I’m keeping FP Newspapers Income Fund on the Dividend Watch List as a hold.

The rest of the Dividend Watch List–excluding oil and gas producers, which are always at risk to cuts depending on energy prices–includes: Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF), InnVest REIT (TSX: INN-U, OTC: IVRVF), Primaris REIT (TSX: PMZ-U, OTC: PMZFF) and new addition Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF), whose prospects are discussed in this section.

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

Alberta’s Royalty Muck–The energy-rich province may be on the verge of yet another change to its royalty structure. Lower is better, but consistent is best; producers would appreciate a little predictability so they can plan cost-intensive exploration and production activities. Though companies would be pleased to have a little more wiggle room with cash-flow management, it still may be too late for Premier Ed Stelmach to stay atop the Alberta government, particularly with an insurgency brewing on his right.

More Information

The following is a regular repeat from prior issues.

Whether you’re a veteran reader or a newcomer, I encourage you to take a moment to navigate the Canadian Edge website, which includes a wealth of information not included with the downloadable monthly “pdf” version. One of the most useful features is our live quote feed in How They Ratefor US dollar prices, distributions and percentage yields of trusts and high-yielding corporations. Note that our quote service sometimes includes special annual distributions along with the regular monthly payments.

Clicking on the Toronto symbol (suffix “.UN”) will take you to the website of our Canadian partner, Toronto-based MPL Communications (133 Richmond St. West, Toronto M5H 3M8), which includes price charts and access to press releases.

If you click on the US symbol you go immediately to a chronological listing of every Canadian Edge and Maple Leaf Memo article in which that trust has been featured. You can also use that page to access articles on other trusts by typing in the relevant exchange and symbol in the “Search Query” box at the top of the page.

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 website 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.

How They Rate can now be accessed several places on the home page. The Income Trust Tax Guide has backup to file distributions as qualified dividends. “Eye on Trusts” and “How They Rate” are accessible via the shaded box in the middle column.

Roger S. Conrad
Editor, Canadian Edge