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Master Limited Partnerships (MLPs) – A Brief Overview

BLOG, EDUCATION  |  28 Feb 2011

Although Master Limited Partnerships (MLP) have sort of flown under the radar of many investors, over the last couple of years they are beginning to be “discovered” by more and more investors, as well as fund companies looking to profit in this area as well. With an annual total return of 15.5% since 1995 and current yields in the area of 6% it is easy to see why. Let’s take a brief look at what MLPs are and why they have become more popular of late.

MLPs are companies that operate in the transportation, processing, refining, storage, marketing and production of minerals or natural resources. There are essentially four areas of natural resources operations that fall into the qualifications to operate as an MLP:

  • UPSTREAM – Natural Gas, Oil & Coal reserves & drilling.
  • MIDSTREAM – Oil & Gas pipelines, storage, & transportation.
  • DOWNSTREAM – Refineries, transportation by rail, truck or boat.
  • OTHER – Timber, Geothermal Energy, Fertilizers, etc.

The majority of MLPs are in the energy sector. Many own and operate pipelines primarily for natural gas, oil and propane; they transport the resources from one place to another. They effectively operate as “toll collectors” that collect a “toll” from oil and gas producers who use the pipelines.

MLPs operate as a publicly traded limited partnership whose shares of ownership are referred to as units. It combines the tax advantages of a partnership with the liquidity of publicly traded stock. It also does not pay tax at the corporate level but, rather, at the unitholder (shareholder) level. To qualify for this favorable tax treatment, 90% of their income generated must come from what the IRS terms as qualified sources, which includes producing, processing or transporting natural resources. Although MLPs do not have a set requirement to distribute a certain percentage of their income to maintain their tax status, they do as a matter of policy distribute a large percentage of their current operating cash flow to unitholders. This differs from Real Estate Investment Trusts (REITs) which are required to distribute at least 90% of their ordinary income to shareholders to avoid corporate-level taxation.

Comparison of the Alerian MLP Index (in black) to the S & P 500 over the last 5 years

(The chart does not include dividends, which would make the difference even larger)

Why MLPs Are Getting More Attention?

As mentioned in the opening paragraph, the 15.5% annualized return since 1995 is one reason, but other reasons include:

Qualified Dividends – Most distributions qualify for 15% dividend income tax treatment.

High Yields – In this current low interest rate environment, it is tough to find attractive yields on income producing securities. Currently many MLPs are yielding north of 6%.

Price Appreciation – Most MLPs, in addition to their attractive yields have also had very good price appreciation as well.

Reduced Correlation with the Stock Market – MLPs have historically only had a modest correlation with the stock market. This has made them a good portfolio diversifier.

Predictable and Growing Cash Flows – Since many companies that operate in this space are effectively “toll” collectors, their revenues are generally fairly stable, since it is predicated on the amount of resources that flows through the pipelines, not so much the price of the natural resource.

Risks of Investing in MLPs

Even though MLPs have a lot of good things going, to get those kind of returns is not without some risks as well, such as:

Higher Interest Rates – Higher interest rates generally have an adverse effect on income securities such as bonds, REITs and MLPs. In a rising interest rate environment, MLPs may be subject to price weakness (although in the current rising rate environment we have been in since November 2010, MLPs have done very well). However, MLPs may perform better than bonds since the companies have the ability to grow their cash flow base and increase their distributions.

Tax Complexities – For many people, the K-1 tax form that individual MLPs issue each year can be daunting (see below), and a reason to not invest, however, as shown below, there are plenty of alternative ways to invest in this market, and avoid this issue.

Volatility – Even though MLPs have reduced correlation with the markets, they still can go through periods of extreme volatility. In the credit crisis of 2008, MLPs were hit hard along with virtually every other asset class. Part of the reason was that a lot of large hedge funds had significant exposure and were forced to liquidate which put further pressure on prices. However, during this time very few MLPs cash flows and distributions were affected.

Tax Law Changes– MLPs currently enjoy an attractive tax structure, with higher tax rates, and the government looking for ways to increase tax revenues, there is always the possibility that these advantages could be taken away in future tax legislation which could have an adverse effect on the sector. On an individual level, with current tax laws the 15% qualified dividend exemption is set to expire at the end of 2012, so this could reduce the tax efficiency of MLPs.

Ways to Purchase MLPs

You can purchase MLPs in one of five ways:

Individual Company – There are about 80 individual companies that trade on the stock exchanges that you can purchase. Some of the larger companies are Energy Transfer Partners (ETP), Kinder Morgan Energy Partners (KMP), and Magellan Midstream Partners (MMP).  Since you are now a limited partner, you are entitled to distributions and share price appreciation or depreciation that may occur. As long as you continue to be a unitholder you will annually receive a fairly complex tax form called a K-1, which you will use to report your income received from the MLP during the tax year. If you happened to own 5 MLPs you would receive 5 K-1’s. This form can be cumbersome, and it will make your tax return a more complicated, but if these companies continue to do well it can be worth it. You also have to be careful buying these companies in your IRA, because they generate what the IRS calls Unrelated Business Taxable Income (UBTI), and if you have more than $1,000 of this during a year, the amount over $1,000 is taxable to you in the IRA. If you are looking to avoid the hassle of the K-1 form, the following four options are also available:

Closed End Mutual Funds – There are a handful of closed end mutual funds, which invest in MLPs. Funds such as Fiduciary/Claymore MLP Opportunity Fund (FMO), & Tortoise Energy Infrastructure Corp (TYG) , that have been around for some time. Closed end funds also trade like stocks, but can trade at a premium or discount to the underlying holdings. The advantage of buying a closed end fund is that you get a diversified portfolio of MLPs, run by an investment manager, receive a 1099 tax form (much simpler) instead of a K-1, and can hold in an IRA without any tax problems. The disadvantages are some closed end funds can have rather high fees, and some may use leverage to enhance returns and yields, but can also make them more volatile.

Mutual Funds – Within the last year or two there have been a couple of fund companies that have started traditional mutual funds that invest primarily in MLPs. The advantage of these over closed end funds is that they do not use leverage, and have lower expense ratios. So far the new mutual funds have shown similar results to the closed end funds that have been around for some time. The mutual funds also issue 1099 tax forms instead of K-1s and are IRA friendly as well; since no UBTI is generated. Steelpath runs 3 funds that each takes a slightly different approach. Another company called Cushing began in October 2010. There are also more companies that are in the process of launching funds or have just done so recently.

Exchange Traded Funds (ETFs)ETFs have become very popular with many investors because of their ease of use and flexibility compared to mutual funds. ETFs will have the same benefits as the traditional mutual funds (maybe even lower expense ratios), but with the flexibility of an ETF that trades like a stock. They will also issue 1099s, do not use leverage, and would also be IRA friendly. Alerian is a company, which has for years kept a benchmark index of MLPs; they started an ETF in 2010 as well called the Alerian MLP ETF (AMLP) which is based on this index. All of the other funds listed above are actively managed funds compared to the ETF which is a passive index of MLPs.

Exchange Traded Notes (ETNs)ETNs are very similar to ETFs in the way they trade, but are actually a debt security in that it combines the features of an ETF with a bond. The returns of the ETN are based upon the performance of a market index and the value of the ETN can be affected by not only the market index it tracks but also the underlying credit of the firm that issues the ETN, since it is an obligation of the issuing company in much the same way as a bond. JPMorgan has issued an ETN based on the Alerian MLP Index (AMJ) that has performed very well since its inception in 2009.

Where Are We Now?

MLPs have had a very nice run the last few years, and still make a very compelling long term investment for a diversified portfolio. However, some indications are that, you may consider waiting for a correction in the market before committing new money to this area. Currently, the yield on the Alerian MLP Index (AMZ) is right around 6%, which is near the low end of the range of yields that MLPs have enjoyed. The record low was 5.37% in 2007, before the 2008 swoon.

Another valuation metric to strongly consider is the yield spread between the MLP Index and the yield on the 10 year U.S. Treasuries. In July 2007, the spread was as low as a few basis points, and by the end of 2008 the yield spread was about 1200 points (12%). Currently in February of 2011, the yield spread is around 260 basis points (2.6%), which is also getting close to the low end of the historical range. Historically, when the yield spread gets narrow, MLPs have run into some headwinds, so it is important to be cognizant of the yield spread.

Overall, the MLP sector can be a very lucrative market sector to invest in; with attractive yields, good tax efficiency, the chance for price appreciation, and a modest correlation to equities, they can make a good addition to a diversified portfolio.

Disclosure: Nothing in this article constitutes investment advice or recommendation as to the suitability of any product or security mentioned above.