It’s time to answer the “who, what, when, where, and why” of investing in master limited partnerships (MLPs)…
Andrey Dashkov, senior research analyst at Miller’s Money Forever, is the rare person who, when you asked for a hammer comes back with a hammer, nails, staples, and glue. In short, he often comes up with better solutions to tricky problems than I ever thought possible.
Since Andrey and I are on a nonstop mission to unearth the best opportunities for generating safe income, we have looked to MLPs more than once. Many Business Development Companies (BDCs) and Real Estate Investment Trusts (REITs) also fit the bill. Today, however, we are focusing exclusively on how MLPs can produce a healthy and steady income without exposing your nest egg to unwelcome risks.
The Nuts and Bolts of MLPs
By Andrey Dashkov
An MLP is an entity structured as a limited partnership instead of the traditional C-corporation. This allows the company to avoid corporate-level taxes. The limited partners pay most of the taxes, which means that MLPs are essentially pass-through entities.
In the United States, the net effective rate of corporate income tax is 40%. That means a corporation calculates its profit, pays the appropriate income tax to the government, and then pays dividends from what remains. With an MLP all the profits are passed through to the unit holders.
While a traditional corporation can choose to pay a dividend, an MLP does not have that option. In order to maintain their status, MLPs are required to generate at least 90% of their income from qualifying sources and distribute the major portion of that income. In most cases these sources include activities related to the production, processing, and distribution of energy commodities, including gas, oil, and coal.
The government gives a special treatment to these activities to encourage investment into the United States’ energy infrastructure.
Limited partners (LPs) own the company together with a general partner (GP). The GP takes care of the day-to-day operations, typically holds a 2% stake, and can usually receive incentive distribution rights (IDRs). LPs, called unit holders, (which we can become by buying shares of publicly traded MLPs) receive dividend-like cash distributions. LPs, unlike traditional shareholders, do not have voting rights.
There are many advantages to MLPs, including:
- Attractive yields;
- Inflation protection;
- Portfolio diversification;
- Tax advantages; and
- Resilient business model.
Attractive Yields
MLPs pay various yields that average 5-10%. Data for the Alerian Index, which tracks the top 50 MLPs, show that in Q2 2013Â MLP yields varied from 3-12%, with an average of 6.5%.Besides the actual yield, MLP investors can count on distribution growth. Dividends per share of Alerian Index constituents grew at a compounded rate of 4.1% over the past five years.
Inflation Protection
Several factors hedge against inflation:
- Inflation-adjusted contracts renewed periodically;
- Distribution growth has historically outpaced the growth in CPI; and
- MLP unit (share) prices are weakly correlated with movements in inflation and interest rates.
Portfolio Diversification
MLPs have a low correlation to other asset classes, including equity, debt, and commodities. However, for a short time they may correlate with any asset class or the market in general.
MLPs are less volatile than the broad market. Currently at 0.5, the average beta of Alerian Index, is quite conservative. This suggests that if the broad market goes down by 10%, we should expect the Alerian Index to drop by 5%. An individual company’s volatility may stray from the average, but in general MLPs should be much less volatile than the market as a whole.
