Forget Interest Rates, MLPs Will Continue to Make You Money

Even minutes from the most recent meeting of the Federal Open Market Committee, signaling an October end to bond purchases, were not enough to move treasury rates out of their funk. Yields have hovered around 2.5% for two months and are down significantly from the beginning of the year. Against this environment of stable rates, bonds and bond-like investments have done well, but it is only a matter of time before rates start to increase again. When that happens, as it did late last year, investors may rush for the exits in dividend-paying stocks and other bond-like investments.

Despite what will surely be a chorus of warnings about master limited partnerships (MLPs), the outlook will still be good for these income investments.

Rates go up, prices come down
The problem for investors is in a fundamental rule for bonds: When rates increase, prices decline because the fixed-rate coupons are less attractive. While high-yielding stocks like utilities and consumer staples have a growth component, share prices behave similarly because capital appreciation is relatively limited. The phenomenon is evident in the 12% plunge in shares of the Utilities Select Sector SPDR (NYSEMKT: XLU  ) last year when hints of an asset purchase tapering program sent rates up 0.9% in just six weeks.

MLPs distribute most of their cash flow to unitholders, and many investors are worried that rising rates will hurt an otherwise spectacular investment. The Alerian MLP Fund (NYSEMKT: AMLP  ) has returned 4.2% over the last year on price appreciation and 6.6% on cash return. Partnerships generally have high distribution yields, averaging 4.1% over the 22 midstream companies I cover, and unit prices typically move up or down with other bond-like investments.

Beyond this, rising rates could also hit the group's business model. Since partnerships distribute most of their income, they must continuously tap the debt and equity markets for funds. With liquid and cheap money in the debt markets, fundraising has not been a problem over the last several years. When rates rise, the company is forced to pay higher rates and may issue more units instead of taking on more expensive debt.

History shows MLPs strong even with rising rates
Despite all this, and the fact that rates will likely increase over the next couple of years, MLP investors can be confident that the group will still provide a relatively strong return.

Many investors look to the yield spread between income investments and the rate on the 10-year treasury. The idea is that decreasing yields on higher asset prices makes the investment less attractive against the risk-less Treasury bond. When this happens, investors would have a preference for Treasuries or other income investments. The graphic below shows the yield spread of the Alerian MLP Index against Treasuries over the 16 years to 2012 and the performance of the index over the next year.

The MLP Index currently yields 5.26% against the 2.57% yield on the 10-year treasury. That spread of nearly 2.7% is within the second most frequent range and corresponds to an average gain of about 13% in the index over the next year. While shares of MLPs have done well over the last two years, decreasing the yield from 6.3% and the spread over treasuries by 200 basis points, it really isn't until the spread narrows to less than 1.5% that the average forward returns fall below 10% a year.

MLPs and other income investments
While partnerships have lagged stocks in the goldilocks environment of late, risk-adjusted returns are nearly identical. The chart below compares the performance of the Alerian MLP Fund against the SPDR S&P Dividend Fund (NYSEMKT: DVY) and the iShares Core US Aggregate Bond Fund (NYSEMKT: AGG).

The dividend fund has benefited from strong capital appreciation and returned a cumulative 55.8% over the last three years. The MLP fund has done well but has only posted a total return of 40.6%, and the bond fund has returned just 10% over the period. Volatility for the MLP fund has been lower at 11% over the period against 15% volatility in the dividend fund and 3% bond fund volatility. Risk-adjusted returns for the dividend fund and the MLP fund are nearly identical.

Fund for diversification, but I prefer individual partnerships
One of the several MLP ETFs will offer the most diversification and the lowest volatility, but I prefer investments in individual partnerships. Funds trade like stocks, and investors don't enjoy the tax deferral benefits that come with investing in the partnerships.

MLPs may exhibit some volatility if the specter of rising rates spooks the markets again, but history shows the group's potential in anything but extreme rate volatility. While the yield spread between MLPs to Treasuries has narrowed over the last year, it is still associated with forward returns of 10% or better. While investors with a very low risk tolerance may prefer funds holding a basket of partnerships, I prefer investment in individual partnerships for higher returns and tax benefits.

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