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With 10-year Treasury yields unlikely to keep up with inflation, income investors have found themselves in a quandary. Many have turned to the stock market and have found solace in mortgage REITs, which tend to sport some pretty impressive payouts.
Two of the most popular ones, Annaly Capital (NYSE: NLY ) and Chimera Investment (NYSE: CIM ) , offer juicy yields that range from 12% to 14%. But with both these companies having cut their dividends several times over the past few years, the sustainability of these monster yields has come into question. While mortgage REITs have benefited tremendously from the Fed's actions to keep short-term rates near zero over the past four years, the situation going forward looks less sublime.
Some of the more serious headwinds mortgage REITs face include narrowing interest rate spreads and an accelerating trend of prepayments, courtesy of the refinancing boom. The simple yet lucrative business model these companies employ – borrowing money at low short-term rates to purchase higher-yielding assets – no longer seems as attractive as it used to.
But there's good news. Mortgage REITs aren't the only high-yielding game in town.
The alternative high-yielding investment
Enter master limited partnerships, or MLPs. Just a decade ago, most investors would probably have shrugged when asked about MLPs. But in recent years, these tax-advantaged companies have become staggeringly popular.
Just this year alone, more than $3 billion has flowed into the JPMorgan Alerian MLP Index ETN and the ALPS Alerian MLP ETF – the two biggest exchange-traded MLP products. And several individual MLPs are currently trading near their 52-week highs, further reaffirming the high demand for these investments.
While risks remain, I think the fundamentals for many energy MLPs still appear very strong. Here are three reasons why.
Spread between MLPs and U.S. Treasuries
One method of judging MLPs' relative attractiveness is their spread with the U.S. 10-year Treasury.
As Credit Suisse senior analyst John Edwards points out, when this spread is above 400 basis points, the sector tends to deliver above-average returns over the next year. In fact, historically, when the spread has been higher than 465 basis points, the sector has never had a losing year. And when the spread has been between 500 and 549 basis points, returns have averaged roughly 40%, according to Edwards.
However, while these historical trends definitely add a lot of weight to the bullish case for energy MLPs, it's important to remember that Treasury yields linger near record lows due to a confluence of central bank buying activities and a flight to safety appeal from foreign investors. Ultimately, rates will have to rise, which questions the belief that MLP sector returns will match their historical norms.
High and rising energy infrastructure demand
Another important reason why midstream MLPs are still attractive is their excellent position to capitalize on the high demand for energy infrastructure. With the tremendous discoveries of shale deposits throughout North America and the commercial use of hydraulic fracturing and horizontal drilling to unlock their potential, many argue that the U.S is in the midst of an energy renaissance.
Natural gas production remains extremely strong and has led to a massive oversupply of the commodity, which has helped push prices very low. Similarly, oil production is at a 15-year high with states like Texas and North Dakota leading the way. All this output needs infrastructure to store and transport it – something with which our country is woefully undersupplied.
That's where midstream energy MLPs come in. They own and operate the pipelines that transport commodities like crude oil, natural gas, and natural gas liquids, as well as the facilities and plants used to store and process them.
With no signs of U.S oil and gas production slowing down anytime soon, these companies will benefit greatly from the build-out of domestic energy infrastructure. According to the Interstate Natural Gas Association of America, roughly $10 billion per year in midstream infrastructure investment will be required over the next 25 years.
Stable, fee-based business models
Of course, as with any investment, there are risks to consider. Many of the risks to the MLP sector are macroeconomic and therefore cannot be diversified away. The upcoming fiscal cliff, sovereign debt and banking troubles in Europe, and slowing growth in China are the major ones. These issues affect the outlook for economic growth, and in turn, the demand for commodities.
However, even with these looming risks, some names within the midstream MLP universe are more defensive than others. For example, if a company's revenue is derived mainly from fixed-fee contracted assets, it tends to be less vulnerable to macro and other risks. Contracted pipelines are mainly subject to capacity charges, which means there's not as much volumetric risk as with non-contracted pipelines. Hence, the cash flows from contracted pipelines are quite stable and predictable.
Companies that meet these criteria include Energy Transfer Partners (NYSE: ETP ) , Kinder Morgan Energy Partners (NYSE: KMP ) , and Enterprise Products Partners (NYSE: EPD ) . All three derive a large chunk of their operating incomes from fee-based long-term contracts. This business model, often likened to that of a tollbooth, affords a great deal of cash flow stability, as well as visibility into the likelihood of future distribution increases.
All in all, there's not much to complain about with midstream MLPs. They tend to offer solid yields, a decent chance of capital appreciation (depending on which ones, of course), and a relatively low degree of correlation with other stocks and asset classes. While it's true that investing in MLPs isn't as cut and dry as investing in more traditionally structured energy companies, once you conquer the hurdles of taxation, I think they're still one of the best options for income investors out there.
To find out more about the risks facing mortgage REITs and whether or not your investment is safe, be sure to check out The Motley Fool’s recently released in-depth report on Annaly Capital Management. It outlines three essential points that all current and prospective Annaly investors need to know, as well as a host of other important information put together by our analysts. On top of that, the report comes with a full year of exclusive updates. To unlock your investing edge, just click here.