Non-traditional income investments – Part 3 of 3
Happy fifth anniversary to the most hated bull market ever! I’m glad the bull doesn’t read the press coverages…
A wonderfully fine example of how markets go in cycles was made last Thursday, the 6th, when we set a new, all-time intraday high in the S&P500 at 1881.84. Coincidentally, it was five years ago exactly in March, 2009 when the same index made its rather ominous generational low at 666.79. (1)
This seemingly almost daily making of new record closes can be more than a touch confusing for investors. That is until they realize that a series of new highs comes with bull markets, especially in what’s termed the expansionary period. For the record, this week’s effort is the S&Ps 50th record close over the past year. (2)
By the way, we’re not alone in our market recovery. According to Bloomberg, the MSCI All Country World Index traded at its highest level in six years on Thursday as well. And, according to Bloomberg’s calculations, the current market cap of global equities now exceeds its pre-recession high.
And now, behind door number 3…
The third in this series is a unique income-producing investment. If you’re willing to deal with less predictability and more admin, it could prove to be a very good income source for you. It’s called a royalty trust and, like the MLPs I talked about last week, these are primarily in the energy business.
A royalty trust is a type of corporation created to act as the owner of the mineral rights to wells, oil and gas fields and similar properties. It exists only to pass income generated from the sale of the property’s assets to shareholders. Like a REIT, no income tax is paid at the corporate level as long as the bulk of income (at least 90%) is passed-through directly to shareholders in the form of distributions or dividends.
The typical energy royalty trust holds production rights to a group of oil and/or gas fields. Generally, the oil and gas fields held are mature and will gradually be depleted over a number of years. Until the fields are fully used up, they continue to produce solid cash flows with minimal need for investment. The infrastructure to pump, store and transport the production is already in place. It’s these cash flows that back up the trust’s distributions.
In addition to allowing you to achieve high distribution returns, royalty trusts allow you to speculate directly on commodities such as gas and oil without having to buy futures contracts or use the other investment vehicles traditionally associated with commodity trading.
These can be a great investment tool for people who don’t have the interest, the resources or risk tolerance to buy their own wells. Additionally, since trusts often own numerous individual wells, they represent a convenient way for the average investor to diversify investments across a number of properties. Also, since commodities are considered a hedge against inflation, the popularity of royalty trusts, as well as the REITs and MLPS, increases as these types of investments often rise as inflation rises.
Basically, owning a trust of this type is like owning a piece of a stream of oil and/or gas production. And, also like the REITs and MLPs, the royalty trusts are publicly traded and can be easily bought and sold.
There are two basic types – American and Canadian. These are so-called due to where their energy sources are located and with regard to their internal structure. The short version is that American trusts are a case of “what you see, is what you get.” Since the mid-80s, Congress has said that they cannot add any new producing properties, once the trust is set up. Therefore, the production (and cash flow) in an American trust will, at some point, stop. At that time, the trust will be dissolved.
Canadian trusts can, potentially, add new properties. However, since the announcement of the Canadian “Tax Fairness Plan” in 2011, approximately 90% of the Canadian trusts have converted to corporations, merged with other companies, or simply liquidated.
I’m not even close to being a tax expert. However, I do know that the tax implications of investing in royalty trusts can be complicated.
Distributions from trusts are taxed as regular income, rather than at the lower 15% dividend tax rate, and you may have to file tax returns in the states where the trust operates. The good news is that you don’t pay taxes on a good chunk of these distributions until you sell your units. This is because distributions are considered returns of capital. This reduces your cost basis rather than generating a current tax liability. Unit holders are also entitled to certain deductions based on the depreciation of the trust’s assets.
When you sell, your cost basis for a royalty trust is NOT your purchase cost. The important thing here is that you must reduce your cost basis each year for the depletion deduction as your cost basis changes every year. Each royalty trust will issue instructions on how to compute the annual depletion deduction.
The biggest challenge I see with these is their lack of predictability. Not in terms of how long they may last but in the amount of your annual cash flow. The cash flows are tied directly to the market prices of gas and oil. Unlike the MLPs, there is no Congressional “floor” for earnings. So, as the energy prices rise and fall, so too can your distributions.
Entirely for your education and reference, here’s a sample of some of the 15 publicly-traded American trusts. You can look up the issues for their price and distribution histories, as well as the location of their properties to help you decide if these can work for you.
I hope you’ve found that these last three letters have helped provide you with usable income source information. All three – REIT, MLP and Trust – offer good cash flows and potential hedges against rising interest and inflation rates.
If you’d like a review of other types of investments in the letter or would like to talk about how these can be income issues can be used to your benefit, please call or email me.
(1) Sam Stovall, S&P Capital IQ, 7 Mar 2014
(2) S&P/Dow Jones Indices, 7 Mar 2014
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Past performance is not indicative of future returns. Investing in securities of any type involves certain risks, including potential loss of principal. Investment return and principal value in a bond and/or securities portfolio will fluctuate so that investments, when sold or redeemed, may be worth more, or less, than the original investment.
Investing in sectors may involve a greater degree of risk than investments with broader diversification. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.