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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.
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.
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.
If you like energy plays, MLPs aren't the only smart investments out there. We've found another stock that we think has really good potential. Read about it right here in The Motley Fool's special free report on the energy industry and its best prospects. It's free, but only available for a limited time, so click here today.