Master Limited Partnerships for Your Portfolio: Three Key Questions and Answers

Last week Roger Conrad and I gave several presentations and participated in a number of panel discussions at the San Francisco Money Show. Not surprisingly, Master Limited Partnerships (MLPs) were a popular topic of discussion.

As always, our conversations and question and answer (Q&A) sessions with subscribers were enlightening. Here’s a rundown of three of the most commonly posed questions and my answers to each.

Question: With the US federal deficit soaring and President Obama likely to raise taxes, what’s the likelihood that MLPs’ tax-advantaged status will be targeted?

No one can honestly tell you with complete certainty that the government won’t target MLPs' tax-advantaged status. That being said, the near-term risk of such a tax change appears slim.

Recent Congressional action relating to MLPs has tended to expand the scope of the sector, not limit its growth. For example, the Emergency Economic Stabilization Act of 2008 (aka The Bailout) expanded the MLP structure to include forms that transport and store renewable fuels such as ethanol. The insertion of this clause into the bill was broadly bipartisan.

One area that is at risk: carried interest. Although the specifics of carried interest are rather arcane, the effect is that some hedge funds and private equity firms can pay their partners carried interest distributions and have those distributions taxed at capital gains tax rates. This issue came to the attention of lawmakers when the The Blackstone Group (NYSE: BX) and a handful of large private-equity firms went public as partnerships. This is one major reason we’ve rated all of the investment partnerships a Sell in our How They Rate table.

Last year legislation passed the House that would have taxed carried interest payments as ordinary income, but the bill was aimed solely at investment-management partnerships. That law ultimately failed to pass the Senate. However, the President did propose similar legislation as part of his budget.

But the point is somewhat moot, as traditional MLPs don’t pay carried interest. Bottom line: Legislation targeting carried interest is likely to pass, and estimates suggest that it will generate around $24 billion in additional revenues for the government over the next ten years. But these provisions would have no effect on our recommendations.

Second, the MLP sector is relatively small and likely below the government’s radar. Although carried interest provisions could generate significant additional revenues for the government, recent reports suggest taxing MLPs as corporations would yield no more than $500 million in annual incremental revenues--a drop in the bucket when you consider the size of the US deficit.

Question: Should I hold MLPs in tax-advantaged IRA accounts?

It is not illegal to hold MLPs in an IRA account; however, some of the income you receive from the MLP is unrelated business taxable income (UBTI). UBTI income over $1,000 per year can be subject to tax even though it’s generated by a firm in a tax-free retirement account.

You do not have to pay taxes related to UBTI directly; this tax would be paid by the company acting as custodian on your IRA, and the custodian would also be forced to file the appropriate forms with the government. However, the custodian would pass along those costs to you.

Second, because MLPs are already tax-advantaged it makes sense to hold them when possible in a taxable account. After all, one of the main attractions of MLPs is the tax deferral of return of capital income; you don’t get this advantage inside an IRA account.

There are several MLPs and related investments you can hold in an IRA that do not generate UBTI: Navios Maritime Partners (NYSE: NMM), Kinder Morgan Management (NYSE: KMR) and Kayne Anderson Energy Fund (NYSE: KYE).

As we explained in the June 18, 2009, issue of MLP Profits, Maritime Rules, although Navios Partners is technically an MLP, it has elected to be taxed as a C-Corporation for US federal income tax purposes. It has no assets in the US, is headquartered in Greece, and earns no revenues in the US. Therefore, it’s not subject to US corporate income taxes. That means its C-Corp tax election has no real impact on its tax liability.

The real advantage here is that Navios Partners doesn’t report distributions on a Form K-1, as do most other partnerships. Instead, the company reports on a standard Form 1099, just like any other company taxed as a corporation.

Kinder Morgan Management (NYSE: KMR) is almost identical to Kinder Morgan Energy Partners (NYSE: KMP), except distributions are paid in the form of additional units (shares) rather than cash. Such distributions don’t generate UBTI.

Finally, Kayne Anderson Energy is a closed-end fund that invests in a diversified portfolio of MLPs. Like all closed-end funds, Kayne handles all of the tax filling at the fund level and reports distributions to holders on a normal 1099 dividend form.

Question: The industry benchmark Alerian MLP Index has been up as much as 50 percent this year, and MLPs are among the market’s best performing sectors. Is the run-up in the group overdone and are the stocks now overvalued?

Like all indexes that have seen big run-ups, the MLPs will undoubtedly see periodic bouts of profit-taking. In fact, the Alerian Index has pulled back roughly 5 percent from its early August highs.

And late 2008 through early 2009 was certainly a historic buying opportunity for the MLP sector. Yields on even the steadiest and least commodity-sensitive players in the group soared well into the double digits.

But MLPs do not appear overvalued on any historic metric; in fact, the group remains downright cheap. Consider the graph below.

click to enlarge

Source: Bloomberg

This chart shows the difference between the yield on Enterprise Products Partners (NYSE: EPD) and the 10-year US Treasury Bond. Positive numbers indicate that Enterprise is paying out a higher yield than the 10-year. I chose Enterprise because it’s among the largest, oldest and most liquid partnerships in our coverage universe.

As you can see, Enterprise typically offers investors a yield roughly 2 to 3 percent above that of the 10-year Treasury note. However, late in 2008 that spread spiked to around 9 percent--an unprecedented level.

As Enterprise's stock has rallied this year, its dividend yield has fallen and the yield spread relative to the 10-year has dropped to around 4 percent. Although that’s less than half the level that prevailed in late 2008, my graph shows that it’s still offering a higher-than-normal yield advantage to Treasuries. In other words, Enterprise’s chart looks extended, but it’s not expensive by historical norms.

As we’ve noted on a number of occasions, the importance of the normalization in credit markets since the beginning of the year can’t be overstated. MLPs were among the groups worst-hit by the credit crunch. And, in many cases, recent rallies are just returning these stocks to their levels before the collapse of Lehman Brothers almost one year ago.

The correlation between improving debt market conditions and the performance of the MLP stocks is uncanny. Consider this graph.

The red line on this chart represents the Alerian MLP Total Return Index. The blue line is the inverse of a credit market indicator known as the TED spread. The TED spread plots the difference between the London Inter-bank Offered Rate (LIBOR) and short-term US government bonds.

LIBOR is the interest rate banks charge to lend to one another. When LIBOR spikes relative to government bond rates, it indicates that banks are reluctant to lend to one another. Bottom line: When the inverse TED spread rises that indicates improving credit market conditions.

As you can see, the bottom in the Alerian Index late last year corresponds almost perfectly with the big run-up in credit conditions. Much of the rally in the MLPs this year simply reflects the fact that these companies once again have access to credit needed to fund expansion and acquisitions.

Comments

[bradiop:]

Very informative article.
thanks,
brad

Aug 30 08:41 AM

[Danny Furman:]

I agree that MLP equities are among the most attractive investments today. The problem is that everyone is screaming "buy and hold is dead" and no sector in the US, outside of investment banking, has shown real strength. MLPs don't make 10% daily moves or have 400% upside potential in 2 months, so retail buyers of the " V-shaped recovery" and day traders ignore them.
If I had to buy a stock today to hold for a few years, it would likely be a 10%+ yielding MLP like NMM. However, the rest of the market is more overvalued than these stocks are undervalued.

Very nice article that should be taken seriously by anyone crazy enough to invest today for the long term.

Aug 30 09:33 AM

[elliot_mllr:]

One point of interest is that NMM, which I hold, has distributions which are only 35.89% return of capital, whereas those from EPD, which I also own, are 90% returns of capital, as are those from TPP, which I also own and which is being acquired by EDP. I also own LINN and CPNO and ETP and ETE, which give rise to distributions which are 100% returns of capital, and NS and INRGY the distributions from which are 80% returns of capital. All are solid payers. I also own KYE in a qualified plan. It yields over 13% at my cost and since it is in a qualified plan the fact that distributions are in part a return of capital (as I recall about 65%) is not significant to me.

Aug 30 10:55 AM

[La Marque:]

For the average buy-n-holder, CEFs offer the best MLP exposure. The caveats are premium/discount values and standard market valuation cycles. Tortoise, Claymore and Kayne are in this category.

Aug 30 11:58 AM

[Steven Ward:]

The above blogger has just stated why most MLP's are undervalued to their dividenfd paying peers--- tax complexity. Most retail investors are afraid of them.

the astute investor can take advantage of this. One word of caution: MLP's that heavily return invested capital more than most also carry a high tax from Uncle Sam when the owner sells, particularly at higher prices than puirchased.

Aug 30 12:09 PM

[Mike T:]

FWIW, I have a 5% position in MTP, which is a CEF holding a basket of MLPs. It's one of my best performers with a steady dividend and no Schedule K hassle.

Aug 30 02:14 PM

[doubtful:]

My question is, what happens after all capital is returned to investors?
or after the reserves, in case of natural resources as example, are depleted?

Aug 30 02:24 PM

[Uncle Pie:]

When investing in MLPs, be aware of the "incentive distributions" paid to the general partner. Most MLPs have a provision that once the distribution per share rises above certain levels, the general partner is entitled to a larger percentage of the cash flow. After a certain point is reached, the "incentive distribution" often maxes out with an extra 50% of the cash flow going to the general partner. This is referred to as the "high splits". Some MLPs, to their credit, have capped the incentive distribution at 25%. Enterprise Products, EPD, referenced in the article, is an example of an MLP with a 25% max. It's all in the prospectus, but you should know that when you invest in a "high splits" MLP, you are basically putting up 100% of the capital for 50% of the return. The author owns units of EPD and several other MLPs. The author was pleased with the performance of his MLP securities during the recent market meltdown relative to many other holdings!

Aug 30 04:17 PM

[Emerald:]

The better MLP's continue to purchase reserves or simply own pipelines that carry the oil or gas (no reserves issue). After they return 100% of capital, you have a zero basis and would pay taxes on the full sales price. You could donate these shares to charity and get a tax deduction in return.


On Aug 30 02:24 PM doubtful wrote:

> My question is, what happens after all capital is returned to investors?
>
> or after the reserves, in case of natural resources as example, are
> depleted?

Aug 30 06:01 PM

[Elliott Gue:]

Thanks for all the great comments. You are quite right to point out that incentive distribution rights (IDRs) are an important consideration when investing in MLPs. I do think a few additional points are worth noting about MLP's GP/LP relationship.

First, I do think IDRs incentive the GP to act in the best interest of the LP holders. The reason is that IDRs are based on the amount of money paid out to LP holders -- the split with the GP increases only when the payout to LP holders rises. In most cases, the GP will totally forfeit any IDR if a certain minimum distribution isn't met.

Second, while you are absolutely correct about the high split set at 50% for most MLPs and 25% for EPD, the calculation is a bit more complex than straight multiplication so the actual percentage take is not as high as that. Rather than bore readers with a lengthy comment, I'll try to post a blog in future with the exact calculation details. For now, suffice it to offer an example: Enterprise Products has a high split of 25% but in the first quarter of this year, the company paid a distribution of 53.75 cents to LP holders and just 9.22 cents per unit to the GP.

Third, there are some alternative partnership structures that do not have a GP/LP relationship. An example is Linn Energy (NSDQ: LINE), a limited liability company (llc). Linn is taxed similarly but has no IDR structure.

Fourth, it is extremely important to look at exactly who the GP is for a particular MLP and how capable they are of supporting the partnership in bad times. For example, last autumn Richard Kinder who controls Kinder Morgan's (NYSE: KMP) GP stated that he and the GP would step up with additional cash needed to fund expansion if credit markets remained constrained. And some MLP GPs are actually energy firms with assets they can "drop-down" to the MLP when times are troubled to shore up cash flows. On the other side of the coin are GPs controlled by private equity firms that may be overly reliant on debt.

Fifth, you can actually play the other side of the IDR coin if you wish -- there are a handful of publicly traded GPs that are taxed like MLPs. Enterprise GP Holdings (NYSE: EPE), GP for Enterprise Products Partners, is one example.

On Aug 30 04:17 PM Uncle Pie wrote:

> When investing in MLPs, be aware of the "incentive distributions"
> paid to the general partner. Most MLPs have a provision that once
> the distribution per share rises above certain levels, the general
> partner is entitled to a larger percentage of the cash flow. After
> a certain point is reached, the "incentive distribution" often maxes
> out with an extra 50% of the cash flow going to the general partner.
> This is referred to as the "high splits". Some MLPs, to their credit,
> have capped the incentive distribution at 25%. Enterprise Products,
> EPD, referenced in the article, is an example of an MLP with a 25%
> max. It's all in the prospectus, but you should know that when you
> invest in a "high splits" MLP, you are basically putting up 100%
> of the capital for 50% of the return. The author owns units of EPD
> and several other MLPs. The author was pleased with the performance
> of his MLP securities during the recent market meltdown relative
> to many other holdings!

Aug 30 07:05 PM

[maryanne:]

Great article. scooped up many MLPs and KYE during their Nov and Feb lows. Tax complexity no big deal but good that the crowds stay back and we benefit. Correct much of the MLP payout is in depreciation which is like return of capital, not taxed as income but reduces your cost basis.

Aug 30 10:11 PM

[GlobalTrekker:]

CEF MLPs are not generally a good investment, IMHO, and you pay a premium above NAV for the tax simplification. They also have onerous management fees on top of the management fees that each underlying MLP charges (e.g., Symbol/Premium/mgmt.fee: FMO/+23.00%/3.6%; FEN/+11.40%/4.8%; KYN/+11.71%/5.9%; SRV/+16.50%/7.7%). They also have equally egregious incentive schemes for their owners. There is a reason you cannot borrow any shares to short these fellows. Full disclosure: I short them every chance I get.

Aug 30 10:21 PM

[skyraider:]

Elliot,
Thanks for your expanded reply to the issue of GP's IDR. It would be helpful if you wrote several articles about the MLP's that do a good steady job for unit holders and ones that we can research.
KYE is an interesting one for many of us because it is able to be held in an IRA which is where many of us actually have most of our investable funds. Sadly, Morningstar does not cover them in depth nor can I find other sites that do. Your post today is the most I have seen that relates to KYE and similar closed end funds. A good analysis of the pluses and minuses of KYE and similar investments would be greatly appreciated.
I did note that as the market was tanking in late 2008 the fact that KYE had 40% or so of borrowed funds made a big difference and could have had a major negative impact on the fund had things continued to go south. Think they may be one of those you referred to that would not have deep pockets to go to in a very bad storm. Anyway, more from you about these would be very helpful.
Thanks,
skyraider

Aug 30 10:29 PM

[GD:]

Don't overlook EEQ, same structure as KMR. Great 6 mo performance. I own both.

Aug 31 10:36 AM

[thinking ahead:]

Here is a good web site for investors wanting to learn more (you will need to dig around in here a little though - not 100% user friendly).
www.naptp.org/

note that the author's San Francisco Money Show reference is listed as the most recent investor event on this web site. I currently own BWP, LINE, ETP, RGNC and PAA. Sold KMP and EPD for valuation reasons, but still like the stories. Got burned a little in NRP when the coal story went south. My favorite plays now are BWP and PAA which have large nat gas storage capacity and benefit from the Nat gas contango.

Sep 01 12:34 PM

[glenwpeterson:]

Well, I haven't followed many of the comments beyond the initial discussion here but I'd say it's a good basic description of the MLP's. However, there are many, many intricacies to each and every MLP company and sector and in that respect, the over-arching term MLP is a bit of a misnomer. They are not, in any respect all the same, in terms of both tax advantages, Incentive distribution rights, consistency of distributable cash flow, General partner and management alignnment with investor interests, you name it.

Some specific comments on the authors article. The best MLP Fund which is non-UBTI sensitive (because it is a CEF) that most objectively correlates to the Alerian-Index is TYY. 65% of it's holdings are essentiallly the largest publically traded, predominantly fee-based MLP's and or GP's. Another MLP he missed in the discussion of non-UBTI companies is TOO. (Teekay Offshore Partners.) The last time I checked Kayne-Anderson (KED?) had private MLP's in it's cef as well. Not nearly as transparent as TYY.

IDR splits are important, but some MLP/LLC's have no IDR's. Think CPNO and LINE (for example.)

Perceived consistency of distributable cash flow determines the spread to treasuries as much as access to credit markets IMHO but obviously both are important. Many MLP"s are considered "commodity sensitive" but for many this is simply not particularly true, as their FERC regulated fees are throughput sensitive (read volume) rather than commodity price sensitive. I won't get into a detailed discussion of this as there are so many nuances as to be almost mind boggling. MLP's with higher yields are normally commodity price sensitive to a large extent, albeit many do a great job of hedging over substantive periods in order to protect distributable cash flow and augment the ability to invest capital in both good and bad times.

Despite the reliability of the income stream for many, they can still get sold off like red-headed step children if the credit markets and or treasury bond markets don't act in a favorable manner.

Overall, if you know what you own intimately, you will be served well. If you don't, buy the big CEF's for diversification and watch the price of oil and NG for clues on when to buy and when to sell.

Best of luck to all.

Sep 01 09:57 PM

[Smackdown:]

About time somebody posted a nice MLP article full of accuracies and with no bullshit or overhyped paranoia. Good job. Only fault was missing EEQ (as mentioned above). KMR and EEQ are the same LLC structure, set up to avoid K1s.

Long all kinds of names, added a boatload at the bottom. On margin none the less (currently took the leveraged profit).... Laughed while the Seeking Alpha idiots were busy trying to short the already imploded market using leveraged ETFs and while they bought $1000 gold with no yield. Tried to tell them to look at MLPs and also bank preferreds at 30-40 cents on a dollar (some up 200%).

Sep 02 12:37 AM

[Charles Lie...:]

Your figures on the managements fees seem exceptionally high. Where do you get those numbers?


On Aug 30 10:21 PM GlobalTrekker wrote:

> CEF MLPs are not generally a good investment, IMHO, and you pay a
> premium above NAV for the tax simplification. They also have onerous
> management fees on top of the management fees that each underlying
> MLP charges (e.g., Symbol/Premium/mgmt.fee: FMO/+23.00%/3.6%; FEN/+11.40%/4.8%;
> KYN/+11.71%/5.9%; SRV/+16.50%/7.7%). They also have equally egregious
> incentive schemes for their owners. There is a reason you cannot
> borrow any shares to short these fellows. Full disclosure: I short
> them every chance I get.

Sep 03 06:46 PM

[Norm S:]

I have shares of NMM in my Roth IRA, So far so good, will other MLPs work in the same way as far as the tax exemptions of a Roth account are concerned?

Getterdone

Sep 08 10:38 AM