A New Challenge for MLP Investors

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In recent years, master limited partnerships have drawn the attention of investors looking to cash in on the boom in energy while at the same time boosting the income they generate from their portfolios. Yet amid all the demand for MLPs, one company is taking an unexpected step -- and it could introduce a new risk for the investors that have used its product to invest in the sector.

The product in question is the JPMorgan Alerian MLP Index ETN (NYSE: AMJ  ) . Yesterday, the exchange-traded note's issuer, JPMorgan, officially made what it sees as its final issuance of ETN units, as the ETN has recently approached its maximum limit on the number of units outstanding. Later in this article, I'll talk about the risks that JPMorgan's decision puts on investors, but first, let's take a look at the mechanics of the alphabet soup behind MLPs and ETNs.

The ABCs of MLP ETNs
Master limited partnerships are tax-favored entities that typically invest in energy and other natural resources. The reason why income investors like MLPs is that as part of their deal to avoid paying corporate taxes, MLPs have to distribute the bulk of their income to their unitholders. That in turn makes MLP yields fairly high, especially when the underlying business is performing well.

One challenge from MLP investors, though, comes from tax reporting requirements. Because MLPs are partnerships, they have to pass through their income to their investors. The way they do so can also be complicated from a tax-accounting standpoint, as MLPs use more sophisticated K-1 forms that require more work than simply putting a dividend number on a single line of a tax form.

In order to avoid the tax complications of MLPs, exchange-traded notes provide a way to allow investors to track the performance of MLPs while having their income treated as interest that's reportable on standard 1099 tax forms. The JPMorgan MLP ETN in particular makes quarterly distributions of the income paid by the index of MLPs that it tracks. With yields ranging from around 5% for Enterprise Products Partners (NYSE: EPD  ) and Plains All American (NYSE: PAA  ) to more than 8% for Linn Energy (Nasdaq: LINE  ) and Energy Transfer Partners (NYSE: ETP  ) , the yield for the ETN -- which tracks those and many other MLPs -- is solidly in the 5%-6% range even after expenses.

Setting limits
Under normal circumstances, issuers of exchange-traded products offer ways to create or redeem units when their value trades out of line with their inherent value. But as JPMorgan notes, because of its unit issuance limitation, the ETN units are no longer subject to the same mechanisms that keep prices in line. In JPMorgan's words, the limitation "may cause the ETNs to trade at a premium relative to the indicative note value. Investors that pay a premium for the ETNs could incur significant losses if that investor sells its ETNs at a time when some or all of the premium is no longer present."

On one hand, the prospect of having shares soar above their intrinsic value is obviously a potential boon for current investors in the ETNs. The ETN units trade near their intrinsic value now, so those who buy units now aren't paying a premium.

What it does require you to do, however, is to monitor any future purchases to make sure you're not overpaying for shares. That's a problem that has arisen with one ETN that tracks natural gas prices, as shares briefly traded at more than double the indicative value of the underlying futures contracts that the ETN tracked. The benefits of the ETN may arguably be worth some small premium, but there's potential for the units to get ridiculously expensive.

Finding alternatives
Because of JPMorgan's decision to stop issuing new units, you may want to look at other ways to own MLPs instead. MLP ETFs are one possibility, although they have their own unique pluses and minuses. Despite the tax hassle, it may be worth it simply to buy MLP units directly rather than going through an exchange-traded product.

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Fool contributor Dan Caplinger loves a challenge. He doesn't own shares of the companies mentioned. You can follow him on Twitter @DanCaplinger. Motley Fool newsletter services have recommended buying shares of Enterprise Products Partners. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is never challenging.

Read/Post Comments (4) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 20, 2012, at 9:41 AM, Quaker08 wrote:

    "Despite the tax hassle, it may be worth it simply to buy MLP units directly rather than going through an exchange-traded product."

    That is the answer for most individual investors. IMO

  • Report this Comment On June 21, 2012, at 11:12 AM, CluckChicken wrote:

    That tax hassle can be a very BIG hassle. Some of these MLPs operate in over 35 states meaning if you hit the limit and must report that income to each state you have just lost a significant amount of time to paper work.

  • Report this Comment On June 22, 2012, at 9:57 AM, mr091468 wrote:

    Why not consider TPZ (pays monthly) and TYG (pays quarterly). I consider these like unto MLP mutual funds. No k-1 hassels. Good array of MLP's both stock units and bonds. TPZ 60% high quality bonds and 40% MLP shares. TYG 100% MLP shares.

  • Report this Comment On December 20, 2012, at 9:34 AM, DickFL wrote:

    I have several MLPs and have not found the tax reporting that much of a hassle. WPZ and EPD are two that among those I have investments in that

    have done well for me.

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