As I pointed out last week, upcoming elections--particularly for governorships--could be critical for a number of companies. I’ll have a full wrap up of the winners and losers in the December Utility Forecaster.

For the most part, however, the stars are still aligned for utilities, as they move into what have traditionally been their strongest trading months of the year. In the power industry, electricity demand continues to push up prices and profit margins.

Robust profit reports at CONSTELLATION ENERGY (NYSE: CEG), DOMINION RESOURCES (NYSE: D), ENTERGY (NYSE: ETR), EXELON (NYSE: EXC) and FPL GROUP (NYSE: FPL) are the clearest proof yet of the strong growth in store for power companies with good assets and far-sighted management.

In the communications sector, we’ve seen company after company report strong results. The only exception, SPRINT (NYSE: S), is floundering due to problems of its own making, basically management’s inability to integrate the acquired Nextel assets. With several old Nextel executives jumping ship, it may take a while to turn the thing around. But the industry as a whole is enjoying rising sales, cash flow and profit margins, as wireless and broadband growth more than offset the steady erosion of traditional revenue streams like local and long distance phone service.

US real estate investment trusts (REITs) also continue to perform well. Here the challenge is to find REITs that the big money has not run up into the stratosphere. For example, one of my former recommendations, BOSTON PROPERTIES (NYSE: BXP), is trading well over the century mark and yields only around 2.5 percent, barely one-third the level of just a few years ago.

What buys that remain are mostly in the residential REIT sector.

Apartment landlords languished for years as mortgage rates steadily fell and would-be renters opted to buy homes rather than lease. That trend reached a peak a little over a year ago, as the cost of buying reached an all-time high versus the cost of renting.

Since then, we’ve seen the trend reverse, and the primary beneficiaries have been residential REITs. Strong third quarter results at HOME PROPERTIES (NYSE: HME) and MID-AMERICA APARTMENT COMMUNITIES (NYSE: MAA) testify that the trend is alive and well.

Specifically, these are the closed-end bond funds recommended in the PF Growth Portfolio. My personal favorite remains the PIMCO STRATEGIC GOVERNMENT FUND (NYSE: RCS), which has an unmatched record navigating all manner of market environments. Interestingly, it’s the family’s only fund not managed by the legendary Bill Gross.

Investors should note that closed-end funds trade a fixed number of shares on major exchanges, rather than mint new shares based on demand, as open end mutual funds do. As a result, funds like PIMCO don’t usually trade at the value of their underlying assets, as open end funds do. Rather, they tend to fluctuate between trading at premiums (more than asset value) and discounts (less than asset value). No closed-end fund should be purchased at a premium of 10 percent or more, including PIMCO.

More important, institutions tend to shun them because they’re less liquid than common stocks, so bargains abound. The key is not to shoot for the highest credit ratings or yields. Instead, it’s to get a company that’s getting stronger financially, and therefore shedding credit risk. That way, you can get appreciation as the issuer’s credit standing improves. And the falling credit risk also offsets the risk of rising interest rates.

No industry is more reliable for coming back from financial weakness than regulated utilities. Almost no matter what or how severe the problem is, utes have consistently been able to put their financial houses in order by repairing relations with regulators and refocusing on providing reliable service, while shedding debt and operating risk.

CMS ENERGY (NYSE: CMS) is one such company that’s made truly Herculean strides in recent years coming back from severe turmoil.

Four years ago, a less than vigilant CEO and too aggressive energy trader nearly pushed the Michigan-based company in to Chapter 11.

Then the board swung into action, hiring a respected auto industry executive to restore credibility and to cut out the bad parts.

Today, CMS is far healthier than it’s been in years, posting stronger operating margins at its core regulated utility business, shedding underperforming unregulated assets that are a legacy of prior management and cutting debt. That’s been a major plus for the company’s bonds and preferred stocks, and the trend appears to have a long way to run. One great way to play is with CONSUMERS POWER PREFERRED B (NYSE: CMS B). Note that its dividend is considered qualified income for US tax purposes, as it’s a traditional rather than capital preferred.

HARD TIMES

My standing advice to all income investors is to build a portfolio of high-quality selections from a wide range of sectors. Not all of your picks will go up at the same time. But strength in one group will typically offset weakness in another, pushing up overall returns while your income keeps on flowing.

That’s not rocket science. Nor can I lay claim to coming up with that approach. But its worth is proven time and again in the markets, most recently with the crash in Canadian trusts.

For most of the past couple of months, prices of many Canadian royalty and income trusts have been declining. The primary reason has been growing uncertainty about energy prices, and a series of dividend cuts by trusts that produce natural gas. And because most investors are not very sophisticated or even care about the quality of the businesses paying trust dividends, even stronger fare were getting hit.

In the last couple of weeks or so, however, even the weakest gas producer trusts seemed to have bottomed. Early cold snaps in much of the Midwest and Northeast had brought into doubt earlier forecasts of an extraordinarily warm winter--which would have been the third moderate season in a row. As a result, natural gas prices started climbing, and gas trusts began to follow suit. So did unit prices of energy services trusts, which stood to gain if energy patch activity remained on an even keel, since many analysts predicted a steep drop off.

Then came the Halloween night announcement by Canadian Finance Minister Jim Flaherty, which was effectively a proposal to tax existing trusts as corporations beginning in 2011. The ruling excluded only Canadian REITs and a smattering of other trusts with unique financial structures. It also proposed subjecting any corporations that converted to trusts in the future to be taxed as corporations, thereby negating any advantage of converting in the first place.

The reaction in the market place has been swift and deadly. Many trusts opened the morning of November 1 down 10 percent or more and--after a brief midday respite--continued to plunge throughout the day. The broad S&P/Toronto Stock Exchange Composite Income Trust Index wound up down 12.4 percent, one of the biggest one-day declines in that market’s history. Many trusts wound up down as much as 20 percent, and the selling continued into the next day as well.

At first glance, the post-Halloween action looks like a repeat of what happened a year ago, when then-Finance Minister Ralph Goodale crashed the market by proposing to tax income trusts. Then, the economic fallout and political opposition forced the government to withdraw its proposal and the result was a titanic rally in trusts that lasted into early 2006.

The decision was made in real cloak-and-dagger style, without even the slightest consultation with the trust industry, which was caught utterly flatfooted. In fact, many people I’ve spoken with have called it the best kept secret in Canadian government history.

Of course, the government’s rationale for its decision is patently absurd. Basically for the sake of saving a highly debatable CD1 billion in lost corporate taxes--at a time when the government is running a massive surplus--it’s gutted the biggest source of investment in its economy and stock market. This week’s crash alone wiped out some CD30 to CD40 billion of shareholders equity.

Worst of all, oil and gas producers will be unable to organize as trusts after 2011. Trust structure was originally set up to promote development of the country’s depleting fields, which the world’s super oils found no longer worth their while. Several sector executives have stated it will no longer be economic to develop these fields once they’re unable to organize as trusts. As a result, Canadian production of oil and gas will decline. The reduced supply will no doubt push up prices. But the Canadian government’s wallet will be significantly lighter.

Of course, Mr, Flaherty no doubt views himself as a conquering hero, saving the Canadian government and its social programs from eventual de-funding by the wholesale conversion of the country’s corporations to trusts. He may come to see things differently if the Canadian market continues to crash and wipe out shareholder wealth, and all those foreign dollars ready to invest in trusts--and pay 15 percent withholding tax--dry up. It’s also going to be a lot harder to fund the country’s massive pension system, and a lot of small savers are suddenly a lot poorer today than they were earlier in the week.

On this side of the border, income investors are faced with a major decision. Should we bail out now after this selling wave, eating our losses in exchange for peace of mind, or should we hang in there in hopes of a brighter tomorrow and possibly buy more at these low levels?.

25 percent of your portfolio in one asset class, you’re setting yourself up to get beat. And even though trusts’ prices are now well below the heady levels of summer, overloading is still a road to unjustifiable risk.

My second caveat is that any Canadian income trust you own should be backed by a strong and growing business. That’s been a requirement of all trusts I’ve recommended over the past several years. The fact that I’m comfortable with the financials and how my picks are run is the main reason I’m not running for the hills now.

I have rated a very large number of trusts as sells for a long time in Canadian Edge. That’s because I either deemed them far too expensive--as was the case with the ultra popular CANADIAN OIL SANDS TRUST (TSX: COS.UN, OTC: COSWF)--or because of iffy fundamentals.

In contrast, the core of trusts I’ve held in CE, UF and PF portfolios have strong businesses that will thrive whether they’re taxed as trusts or corporations. The Flaherty proposal allows them basically four-plus years to adjust to the new taxation scheme, which should allow them to do the job incrementally and effectively.

Most have taken big hits, but as they prove they’re not down for the count, today’s red ink should fade to black. Neither are they likely to start cutting dividends drastically, as that would hit their share prices hard.

At these prices, in other words, the risk/reward relationship for trusts with good businesses is as compelling as anything else out there available to income investors. And as part of a diversified portfolio, risk of holding them is reduced even more.

There remains the possibility that the Flaherty proposal will be modified, either before it’s put into action or sometime in the next four plus years prior to 2011, when the changes to existing trusts are slated to be put into effect. In my opinion, odds are good that trust status will be revived for at least oil and gas trusts, particularly if industry executives’ forecasts of falling production prove on the mark.

If there is any modification we can, of course, expect a rip-roaring rally in the affected trusts. In my opinion, however, that’s not something we should count on by any stretch.

For one thing, I’m obviously no mind reader. Before the Halloween announcement, I was firmly convinced the government wouldn’t risk a financial meltdown and political revolt by the voters who chose it over the Liberal party last year--in large part due to the promise that they wouldn’t tax trusts. However the Conservatives try to sugar coat it with lower rates on some taxpayers, this amounts to a broken promise right up there with the infamous “Read my lips, no new taxes” pledge of a certain former US President.

Given my abject failure to forecast here--which incidentally was shared by virtually every other observer--I’m going to proceed as though this proposal is going through as is. The good news is there are plenty of things worth buying, or holding if you already own them, even under this assumption that the worst case scenario will prevail.

One group all investors will want to take a look at is Canadian REITs. These were specifically left out of the government’s proposed changes. I’ve recommended many of these in Canadian Edge and Personal Finance. They’re a good deal cheaper than US REITs, yield more and are growing faster as well.

The unique nature of electric power trusts’ income streams also lessens the potential blow on them. And one--ATLANTIC POWER INCOME FUND (TSX: ATP.UN, OTC: ATPWF)--is actually organized as an income deposit security (IDS). IDSes are basically part equity and part debt security. As a result, they don’t fall under the classification of trust either and are therefore unaffected.

As for the slammed and battered oil and gas trust and energy services sectors, their fates are going to be tied to energy prices from here on in. As prices rise over the next few years, the best trusts’ unit prices will rise as well, even if they’re eventually forced to convert to corporations. That’s because they’ll be evaluated on the basis of their reserves and output--rather than for big income trust yields as has been the case in the past.

It’s the natural resource story that makes Canadian investments attractive to 2011 and well beyond. Until we see some real global conservation, a move to alternative energies like wind and nuclear, a major new discovery of conventional reserves (oil sands and deepwater Gulf of Mexico drilling don’t count) and probably a demand-killing global recession, the worst oil and gas are going to do is stage temporary declines. Meanwhile, they’ll continue to wend their way higher as the supply/demand balance remains firmly in favor of producing nations.

Natural resources aren’t the only economic activity in Canada, but they are the straw that stirs the drink. As long as those markets are healthy, it will be worthwhile to invest in the best Canadian royalty and income trusts--and it will take a lot more than mistakes by misguided politicians to muck it up. In short, we’ll keep looking for the best the country has to offer.

Roger Conrad is Editor of UTILITY & INCOME