MLPs Continue Their Winning Streak

by: Avi Morris

MLPs continue to be the best performing group in the markets during 2009. The Alerian MLP Index shot up and added to its gains in May:

  • December 31, 2008: 176
  • May 29, 2009: 226 (up 28%)

The comparable Alerian Index with reinvested income (reflecting two distributions) had even better results.

  • December 31, 2008: 428
  • May 29, 2009: 570 (up 33%)

The index slipped in early March along with the market but has been charging ahead, non stop, since then. MLPs are yield instruments and the rising index caused the yield to plummet from a record high of over 15% to only 9% yesterday.

But with gains comes worries. Other yield securities have also done well as risk aversion has been abandoned, especially since March. High yield (junk) bond funds have rebounded sharply from the depths when they yielded around 25%.

REITs have also recovered, but their recovery has flattened in recent weeks with a greater recognition that their high yields are accompanied by high risk. There have been dividend cuts, even at some of the strongest REITs. REIT stocks are feeling the effects. Junk bond funds continue to rise, reducing their yields.

However defaults are expected to rise which will reduce junk bond fund dividends.

MLPs are also yield securities with a very high 550 basis points yield spread above the 10 year Treasury bond yield (200 basis points had been considered a traditional spread). Optimism for MLPs is motivated by a lack of concern about how well distributions are covered (not to mention the basis for increases). MLPs have not had financial problems expanding their pipeline projects during the credit crisis.

Only a few MLPs have had to reduce distributions (so far) to help conserve money needed for debt reduction. Most have been able to extend debt and obtain additional financing for pipeline projects.

However, their ability to generate earnings for existing and higher distributions is more difficult to understand. Many MLPs reported lower earnings in Q1 which generally did not impact distributions because distributions are paid from distributable cash flow per unit, including depreciation and other non cash cash items, which is not reported.

There is a growing disparity between gains for MLPs and junk bond funds versus REITs struggling to make gains and Treasury bond yields which have risen dramatically. Something has got to give. Either high Treasury yields will recede or high yield securities will need higher yields (i.e. falling stock prices) to support a greater sense of risk.