Master limited partnerships, which invest in American energy infrastructure, were popular holdings for income-starved investors when interest rates were at rock bottom and equity markets delivered higher yields.
Depending on the investment, MLPs could kick off yields of 6 or 8 percent or even more, making them good alternatives when U.S. Treasury notes yielded 1 percent or less. But with the Federal Reserve raising interest rates, yields on U.S. Treasury notes are starting to rise, too. The benchmark 10-year U.S. Treasury note hit the 3 percent mark in April. While it’s not eye-popping, fixed-income strategists say it’s a decent yield for an ultra-low-risk investment.
Because of rising rates, many market strategists say it’s time to “de-bond” your equity portfolio and get rid of investments like MLPs. As rates rise, investors need to realize there’s a trade-off between the amount of yield a security has and the volatility of the asset class, says Will Rhind, chief executive officer of GraniteShares in New York. The yield may still be there, but the net asset value may decline. “MLPs are going to be affected by rising interest rates,” he says. “They’ll still be able to distribute a high level of income, but the principal will obviously be affected given the market environment.”
[See: 7 ETFs for Income Investors to Play It Safe.]
Other experts, however, tell investors not to overreact. Some MLPs still offer income investors the yields they need. What investors should consider instead is whether an MLP is so vulnerable to rising rates and higher inflation that the yield might be unsustainable.
Higher short-term rates aren’t a deal-breaker. Andrew Hart, president and chief advisor at Delegate Advisors in Chapel Hill, North Carolina, says he’s less concerned about the Fed raising rates because short-term interest rates don’t affect MLPs as much as long-term rates. Hart is a fan of MLPs. “We just met with a couple of clients and MLPs are probably the only equity asset that we’re telling them to add to at this time,” he says.
The difference in yields between 10-year U.S. Treasury notes and MLPs, known as the spread, is attractive, Hart says. Historically, the spread between the two instruments has ranged between 280 and 300 basis points. The MLPs he likes yield 8 percent versus the nearly 3 percent yield from Treasurys. That 500-basis-point difference “is a very nice spread and has a lot of cushion.”
Some investors shied away from MLPs after the Federal Energy Regulatory Commission recently said that certain interstate MLP pipelines were ineligible for some tax breaks, Hart says. But investors misunderstood the situation as the MLP’s most important feature, its tax status as a pass-through instrument, remains intact. Pass-through investments don’t pay corporate taxes. Instead they “pass through” profits and losses to the owners and investors, who are responsible for paying taxes on their individual portion of the MLP.
What’s more, he says, MLPs are improving their balance sheets by changing their dividend payments. Although distributions may be reduced, MLPs are taking that money to have the ability to self-fund their capital expenditures. When MLPs did poorly a few years ago, many slashed dividends. “Improving their balance sheets gives you greater certainty for distributions,” he says.
[See: 7 Dividend Stocks Yielding 7 Percent and More.]
MLPs are not like other income investments. MLPs are often lumped in with other equity income-producing investments, like real estate investment trusts and utilities, but MLPs act differently when rates rise, says Matt Sallee, portfolio manager at Tortoise Capital Advisors in Leawood, Kansas.
Sallee says Tortoise reviewed how MLPs performed during rate hikes since 2000. In that time, interest rates changed an average of 80 basis points, with the 10-year note rising by that amount. MLP returns averaged 6 percent during that period, versus 5.4 percent for the Standard & Poor’s 500 index. Utilities and bonds had negative returns, he says.
When rates rise because of higher economic growth and inflation, MLPs benefit as those conditions usually mean greater energy use and greater volumes moving through pipelines, which translates to higher revenue, he says.
Some MLPs can also benefit from inflation because they can pass on those costs, Sallee says. Pipelines that carry liquids like crude oil or gasoline adjust their fees annually in accordance with regulators, and that adjustment is tied to the producer price index. That’s not the case with natural gas pipelines, he says. They may be at a disadvantage if inflation rises because many have a fixed fee that does not adjust during the contract life with their customers.
What to look for. The nature of an MLP’s debt can help you determine whether the investment is worth hanging on to. See how much of that debt has a floating rate or a fixed rate as the cost of debt financing will increase if rates rise.
MLPs that are more intent on delivering growth rather than yield may also be shielded from inflation or higher interest rates. “If they’re growing, they’re going to be able to grow through any negative impact from a higher interest rate,” Sallee says.
[See: 7 Bond Funds to Buy as Rates Rise.]
As stock market volatility picks up, Hart says investors should consider if the yield spread between the MLP and Treasury notes is enough to compensate for the MLP’s greater risk. Investors may have to decide if they’re looking for income from a higher yield or price appreciation of the asset. “The key is [are you] being well-compensated by the spread over the 10-year Treasury for taking the risk,” he says. “MLPs are a sub-sector of equities that’s volatile. Prices of the underlying positions can move quite a bit.”
More from U.S. News
7 Ways to Invest in Real Estate with ETFs
7 ETFs to Invest in Transit and Infrastructure
7 Energy Stocks with High-Powered Dividends
As Rates Rise, Do MLPs Belong in Your Portfolio? originally appeared on usnews.com
