MLPs Entering 2009: High Yields Carry High Levels of Risk

 |  Includes: KMR, LINEQ, SPP
by: Avi Morris

December has been a fairly mild time for the markets, coming off the previous period with extremely high volatility in declining markets. High yield securities also suffered a severe market decline. High yield (junk) bond funds, after getting pummeled, finally rebounded a little off their lows. However, their yields typically remain above 20%. REITs also bounced off their lows but remain at depressed levels offering extremely high yields (many well into double digits). MLPs rebounded, but are operating under a dark cloud.

Early in December, the Alerian MLP Index sank to 160. That held, it bounced up to the 180s and then pulled back again to 166. Today it's 169 where it's having a tougher time attracting buyers.

Two weeks ago, Kinder Morgan (NYSE:KMR) raised $900M for expansion by selling units (their equity) and debt. Kinder Morgan, the largest MLP, sent a positive signal about MLPs obtaining finance for expansion in today's difficult credit markets.

Then Constellation Energy Partners (CEP) gave early guidance for 2009 which was grim forcing them to slash the distribution to an annualized rate of 52¢ (formerly $2.25). Even now the reduced distribution yields 20%, after a grim announcement CEP can't buy friends. Additional MLPs are selling in single digits, more big cuts are coming at some MLPs. This industry is not accustomed to cuts where increases have become common.

Over the weekend, Barrons published a positive article on Linn Energy (LINE), a small MLP, which jumped more than $2 (from $12) when the stock market opened on Monday. However, even after the gain, its yield is 18%. Meanwhile, Kinder Morgan's stock (KMR) yields 10½% on what must be considered the premier MLP with the lowest level of risk.

An additional problem for MLPs could be the low prices for energy. It shouldn't, they just move oil & gas through their pipelines. But low prices could cause some hiccups that are not readily apparent such as lower production for higher cost energy.

As yield securities, MLPs were assumed to have yields typically 200 basis points above the 10 year Treasury (now 2.1%). In the past, a spread of 400 basis points was considered extremely high, suggesting a very good buying opportunity. The Alerian MLP Index now yields 12½% (highest rate in 13 years for the index), over 1000 basis points above the 10 year Treasury (a spread never before seen). In these times there is a large amount of rough continuing diamonds. Diamonds with tremendous yields will prove rewarding for investors. The problem is separating diamonds from the rest.

Distributions for Q1, along with earnings guidance, will be announced by mid January giving early clues about 2009 results. Today's extraordinary yields for MLPs are discounting a very, very ugly scenario. However, these high yields should help investors weather stormy seas ahead. If marginal MLPS cut distributions, as expected, doubts about the future and especially future distributions will keep MLPs under a cloud for some time. Those high yields are very tempting, but all carry high levels of risk.

Disclosure: no positions