High-yield stocks attract income investors like moths to a flame, which is why you need to take extra caution. Indeed, when you look at ultra-high-yield names it pays to step back and do a double take before pulling the trigger. Two names that pass this second look are Enterprise Products Partners (EPD -0.15%) and Magellan Midstream Partners (MMP) -- and one that might not be worth the risk is NuStar Energy Partners (NS 1.15%).
1. A long record of success
Enterprise Products Partners offers a distribution yield of roughly 7.3%. It has increased its payment annually for 24 consecutive years. With a nearly $60 billion market cap, it is one of the largest midstream companies in North America. Its diversified portfolio includes pipelines, storage, processing, and transportation assets, and would be virtually impossible to recreate or replace.
But those are just some of the reasons to like Enterprise. It also has a notable amount of exposure to natural gas, which is expected to be a key transition fuel as the world works to reduce its carbon emissions. Its distributable cash flow covered its distribution by a huge 1.9 times in the second quarter. It has $5.5 billion worth of capital investment projects in the works to keep growth going in the years ahead. And it has among the lowest financial debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) levels in its peer group, at around 3.5 times. It is solid as a rock and has plenty of opportunity ahead -- just what a long-term dividend focused investor would want to see.
2. A focus on oil
Another high-yield option in the midstream space is Magellan Midstream, with its hefty 8.1% distribution yield. The distribution has been increased annually since the master limited partnership's (MLP's) 2001 initial public offering (IPO). It is a smaller name in the midstream space, with a market cap of around $10 billion, but it owns some vital assets. Notably, and what sets it apart from Enterprise, is that its portfolio is focused on oil and refined products pipelines. In other words, Magellan lets you take a contrarian position on the energy transition if you believe that oil and the products it gets turned into (such as gasoline and diesel fuel) will be with us for a while. There's also a good chance that the pipelines it owns end up getting used to transport renewable fuels like bio-diesel.
Magellan's distribution coverage ratio is targeted at around 1.2 times, which seems modest compared to Enterprise. However, that's historically been considered solid coverage in the midstream space. And the MLP backs that up with a strong balance sheet, with a modest financial debt to EBITDA ratio of four times. Enterprise is definitely a safer name, but if you want to highlight oil, well, Magellan is a good way to do it.
3. Avoiding debt issues
NuStar Energy has the highest yield here at a huge 10%. Its business is focused around pipelines and storage. However, with a market cap of just about $1.7 billion, it is a fairly small player in the energy sector. It also has more leverage than either of the names highlighted above, with a financial debt to EBITDA ratio of nearly 6.9 times. Notably, it cut its distribution in 2020.
One interesting warning sign comes from the second-quarter earnings release, where the very first headline was "Debt Metrics Improve Significantly." You'd only report that as big news if debt was a pain point with investors, which it is here. The elevated leverage helps explain why the distribution has yet to be increased after the above-noted cut, even though distribution coverage is fairly strong at nearly 1.9 times in the second quarter. Management essentially has to fix the balance sheet before it can really start to reward unitholders for sticking around following a distribution cut. It'll probably muddle through this period, but long-term investors that want income that can be relied on will likely find either Magellan or Enterprise a safer choice.
Stick to the strongest names
When it comes to living off the income your portfolio generates, it pays to take a safety-first approach. And that means ensuring that your investments have the balance sheet strength to handle adversity. Enterprise and Magellan have proven that they do, while NuStar, given its distribution cut, just doesn't live up to that benchmark. And until it gets its debt levels down even more, its high yield just isn't worth the risk for most.
