Belize: Making a Case for Covered Writing Trusts

Despite wrong perception that distribution is guaranteed, these investments can be attractive

Much has been said and written about the problems associated with covered writing trusts. Most of the discussion has been negative, particularly with principal-protected covered writing trusts. The talk centres around their ability to deliver the targeted income as defined in the prospectuses.

Analysts who follow the principal-protected covered writing trusts evaluate them in terms of their performance thresholds, defined as a fund’s "hurdle rate." That is the minimum return the fund must achieve to deliver the distribution target.

This pint is crucial. One of the problems is the perception among investors that the distribution is guaranteed. The income objectives are targets not guarantees. The only thing guaranteed with these structured products is the return of principal either 10 or 12 years from date of issue.

This discussion took centre stage recently when Mulvihill Capital Management Inc. vice president Donald Biggs resigned. Biggs was a main player in Mulvihill’s structured-product division. At the same time, Mulvihill, the leading investment company marketing covered-call writing products, announced that it would be cutting the distribution rate on a number of its principal-protected covered-call writing trusts. In one case (the Pro-AMS U.S. Trust - symbol: PAM.UN) to 4% from 9%; in another (the Pro-AMS Trust - symbol: PR.UN) to 6% from 8.75%. Mulvihill is one of the last managers to announce distribution cuts to its principal-protected covered writing line of funds. For those who have yet to cut distributions, look for them to follow in the near future.

Before going further, there are three points readers should know:

1. I act as a sub-advisor on two exchange-traded principal-protected covered writing trusts: the Sentry Select Blue Chip Income Trust and the Sentry Global Index Income trust;
2. I manage the Croft Enhanced Income Fund, an open-ended (as opposed to a closed-end fund such as the ones listed on the Toronto Stock Exchange) covered writing fund that does not offer principal protection, and;
3. Readers can read previous articles on this subject by going to www.croftgroup.com

There are two issues for brokers:

1. It is important that you discuss with clients the current situation within the context of other investment alternatives; and
2. Can you make a case for buying covered writing trusts now at their current price level?

To the first question, it is important you help clients understand principal-protected covered writing trusts in terms of their risk-adjusted performance attributes. If you believe in the efficiency of the capital markets, then you should accept two basic tenets: there is a particular rate of return for a given level of risk; and higher risk begets higher returns.

When you break down a principal-protected covered writing trust, there is a managed portfolio in which all the option trading takes place, and a fixed component. The managed portfolio distributes income in the form of capital gains. The fixed component promises to repay the principal investment. That promise to repay is underwritten by a chartered Canadian bank.

In terms of risk, principal-protected covered writing trusts are similar to fixed-rate preferred shares of a Canadian chartered bank with, say, a 10-year term. Expect good-quality preferred to yield about 4% per annum, taxed as dividend income.

Now compare the current principal-protected covered writing trust in terms of our preferred-share example. Assuming a capital gains distribution rate of 5% (based on the initial public offering price), these products still yield more than the preferred, both on a pre-tax and, more important, on an after-tax basis. That means the principal-protected covered writing trusts produce higher risk-adjusted returns than similar-quality preferreds. If you buy into that, then the principal-protected covered writing trusts are simply resetting their distribution targets within an efficient market. That alone doesn’t make them bad investments; it simply means the initial targeted distributions were too aggressive.

Now for the future. The market has taken its pound of flesh out of all of these structured products. Most are trading in the $19-$20 range, distributing about $1.25 per annum (taxed as capital gains) with terms to maturity ranging from eight to 11 years. Based on current prices, the revised distribution rate is better than 6.25%, and you have built-in price appreciation. Remember the fixed component will appreciate to $25 over the life of the fund, which adds more than 2.5% per annum on top of your distributions.

The overall return - including distributions and price appreciation - from current levels is close to 9% per annum. That’s about in line with the initial targets. In terms of risk-adjusted returns, 9% is extremely high. That makes these investments attractive at their current price point, but only if you believe the lowered distribution targets are attainable.