In these days of ultra-low interest rates, investors who are looking for or need income from their portfolios are struggling. A roughly 2.5 percent yield on the U.S. Government 10-year note means that it is hard to get any kind of decent return from an average person's available funds at retirement.
This has led many to look at alternative means of deriving income: dividend paying stocks, riskier high yield, or junk, bonds and others. The oil and gas industry provides another such instrument, and one that I believe should be utilized by most investors -- master limited partnerships, or MLPs.
An MLP is a specific corporate structure whereby the company is run by a general partner and owned by a host of other partners. Investors buy into the partnership by purchasing units that are traded on exchanges just like stocks. By law, at least 90 percent of their income must come from operations in real estate, commodities or natural resource. They act as "pass through entities" which is to say that their distributable cash flow (similar to free cash flow in traditionally structured companies) is passed on to the partners by way of dividend payments. In the oil and gas sector, the most common types of MLPs involved in pipelines, and exploration and production.
In the past, MLPs have been used mainly because they have some tax advantages in that some of the dividend paid is classed as return of capital and is therefore tax deferred. The tax consequences of owning MLPs is complicated and has deterred many, but now most basic income tax software allows you to deal with them, so the prospect of doing so is less daunting. Even so, there are complications that often make MLPs unsuitable for holding in IRAs, for example, so consulting with your tax advisor before investing is a sensible precaution.
That said, the reason I believe that they are a valuable tool for investors seeking income, is not because of the potential tax advantages. It is more to do with the risks associated with more traditional yield bearing investments, such as bonds.
Those investing in bonds at the moment are all too aware that the biggest risk to the value of their investments lies in interest rates. Common sense dictates that at some point, rates will begin to rise, and when they do, the value of bond holdings will fall. Given that, having a portion of your portfolio in instruments less susceptible to interest rate moves makes sense.
In the short term, MLPs will react to rate rises like any yield bearing investment, but over time, history suggests that they will recover. In April of 2004, for example, when Federal Reserve head Alan Greenspan indicated a rise in rates, the Alerian MLP index fell initially, but overall, from the end of May 2004 to the end of June 2006, as the Fed Funds rate increased from 1 percent to 5.25 percent, the index gained over 40 percent in total.
There are several reasons for this lack of correlation. Firstly, rates rise when inflation becomes a danger, and inflation increases the price of oil and therefore the income of many MLPs.
Secondly, MLPs usually continue to grow distributions, while fixed coupons on bonds remain static, allowing for significant outperformance. There may be other factors that explain it, but the simple fact is that MLPs represent one of the few-income producing investments that do not necessarily move in tandem with bonds.
In addition, MLP yields are usually significantly higher than those from other instruments. Kinder Morgan Energy Partners (NYSE: KMP ) , for example, currently yields over 6.5 percent.
There is no doubt that, in some ways, MLPs are complicated, but in an environment where earning income is tough and rate rises are considered by most to be a certainty at some point, they provide a great opportunity for decent income that will probably retain value over time.
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