The commodity downturn has hit the midstream and limited partnership spaces hard. There are undoubtedly huge investment opportunities to be found for income-focused investors. But if you're a retiree, capital preservation is just as important as generating income, and these five companies with massive yields of as much as 30% are horrible stocks for you to consider.
Pain in the partnership
The first company with a huge but risky yield hails from the midstream oil and gas sector. Midstream companies generally provide services to oil and gas drillers, helping them get their products from where they are drilled to where they are used. To be fair, the services they provide are truly vital.
But here's the problem: Many of these companies haven't been able to cover their distributions out of the cash flow they're generating. For example, American Midstream Partners (NYSE:AMID) ended 2015 with a distribution coverage ratio of just 0.81 times. With a distribution yield of around 28%, it's pretty clear that investors are concerned that the distribution won't hold, even though management suggests that it will be able to cover 2016 distributions at least 1.1 times over.
To be sure, American Midstream is doing some good things, such as working toward 90% fee-based revenues, cutting capital spending, and reducing leverage. The partnership's general partner is even buying shares in the LP. But with the midstream space in disarray, this relative small fry with a disproportionately large yield isn't a good call for investors who can't afford to lose money if things don't work out as well as planned.
And this isn't the only midstream LP with a big yield and lots of risk: NGL Energy Partners LP, Archrock Partners LP, and Martin Midstream Partners LP sport yields of 34%, 29%, and 19%, respectively. Each case is obviously unique, but you don't get yields like that for no reason. Now is not the time to chase yield in he LP space.
Williams Companies (NYSE:WMB) and Energy Transfer Equity (NYSE:ETE) are two more high yielders, each with yields of around 16%, which retirees should be leery of. For starters, Williams is in the middle of being acquired by Energy Transfer. That $30 billion-plus deal was inked late in 2015, but as the energy market has continued to sag, the deal looks increasingly risky and expensive.
There have been rumors that Energy Transfer wants out of the deal but can't but because of the contract it agreed to. That's a problem. In fact, Energy Transfer's results have been weak of late, and it might have to sell assets or take on debt to complete the acquisition. Selling assets now would probably mean rock-bottom prices and debt would increase the financial risk facing investors, not to mention raising Energy Transfer's interest costs in a weak market.
And that doesn't take into consideration another key danger that could be lurking behind the headlines. Williams Companies has a lot of exposure to Chesapeake Energy, a financially troubled natural gas driller. If Chesapeake falls into bankruptcy, it's unclear whether Williams will have to rework Chesapeake's midstream contracts. Williams, by the way, is also trying to sell assets, at a bad time, to help fund its own capital investment program. This is hardly a gem of a deal for Energy Transfer, and, in the end, adding Williams to the fold could turn out to be a very costly mistake.
While it's true that this deal could work out just fine in the long run, retired investors should probably let others take on the risk that it fails. Williams and Energy Transfer are two more companies that you should be avoiding. (Chesapeake is best avoided, too, but we'll just toss that one in for free.)
When will coal turn?
The last two investments that retirees should avoid are Alliance Holdings GP (NASDAQ:AHGP) and Alliance Resource Partners LP (NASDAQ:ARLP), with distribution yields of around 26% and 21%, respectively. Alliance Holdings is the general partner of Alliance Resource Partners. That means it basically gets paid to run coal miner Alliance Resource Partners, collecting fees and incentive payments for increasing the LP's distributions.
To be fair, Alliance Resource Partners is one of the best-positioned and best-run coal miners in the country. It is, for lack of a better term, one of the cleanest shirts in the dirty laundry pile that is the coal industry. But 2015 marked an important turning point for Alliance Resource Partners -- it stopped increasing its distribution each quarter.
While competitors struggled with weak coal prices and falling demand, Alliance had been able to increase volumes and sales from its highly desirable Illinois Basin coal mines enough to not only offset price weakness but to grow revenues and distributions, too. But that's all set to change in 2016, with management now looking to trim production and holding the line on the distribution. In other words, a bad coal market is finally catching up to Alliance Resource Partners. There's a real risk that it could push the miner to trim its distribution, like so many other competitors have done.
Worse, there's no clear indication of when the coal market might start to recover. Coal is facing intense competitive pressure from low natural gas prices, so key utility customers are switching to the cleaner burning fuel. And increasingly stringent emissions regulations are adding further pressure to the coal industry, as demand for clean alternatives like solar and wind grows. Alliance is likely to hold up better than many peers, but that doesn't mean it will be able to hold its distribution or avoid an even deeper unit price decline over the longer term.
Then there's the tap-on effect for Alliance Holdings GP. Without increasing dividends at Alliance Resource Partners LP, Alliance Holdings GP's dividend growth is dead in the water. And if Alliance Resource Partners is forced to cut its distribution, Alliance Holdings GP's distribution will fall, too, but likely by a larger amount because of the inherent leverage built in by the incentive payment structure. That's why the GP's yield is higher than the LP's yield, a complete reversal of the norm.
For really aggressive contrarian investors Alliance Resource Partners and Alliance Holdings are worth a deep dive. But for retirees, the downside risks are just too great even though the yields are really juicy.
Don't chase yield
If you are a retiree, there's a good chance you are trying to live off of the dividends and distributions from your investment portfolio. American Midstream, Williams, Energy Transfer, Alliance Holdings, and Alliance Resource Partners all offer enticing yields but they are all risky investments right now. Could they turn into diamonds in the rough? Yes. But the risk that they don't is too large for most retired investors to consider them anything more than a gamble. And the last thing you want to do is gamble with your retirement nest egg, which is why retired investors should avoid this quintet.
Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Alliance Resource 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 Motley Fool has a disclosure policy.