I am a fan of MLPs for income investors. Following the 'taper tantrum,' prices on a number of MLPs have fallen substantially. Take Boardwalk Pipeline Partners (NYSE:BWP), for example. BWP was trading at more than $32.5 in late July. Today, it is trading at $25.10. In fact, its trading below where it was when I analyzed MLPs for the article linked above in May 2012.
BWP currently has a yield of 8.49%. What's more, you can sell a call with a strike of $25 that expires in June of 2014 for $1.15. You are in the money by $0.09 per share, but that still leaves $1.06 in realized option premium for an option that expires on June 21 of 2014, which equates to 4.2% in additional effective yield from selling the call that will be accrued over a little more than six months.
If you bought BWP and sold the call, you would have expected income between 12.7% and 16.94% over the next 12 months. The lower estimate assumed that the current income distribution is sustained (8.49%) and that you sell the call for an additional 4.2% and don't sell a subsequent call when this expires in mid-June. The higher estimate assumes that you can sell another call at an equivalent price for the balance of the year. The price at which you may be able to sell another call at midyear is very uncertain, but the call will be worth something--we just can't be very confident of how much. Either way, this is a lot of income.
What else do we want to look at to flesh out the value proposition here? First off, we want to look at the risk levels. By my calculations, the trailing 3-year annualized volatility for BWP is 18.9%. Morningstar says 19.6%. What we really care about, however is forward-looking risk estimates. The June 2014 at-the-money put options on BWP has implied volatility of 28.7% according to eTrade. The June 2014 at-the-money put option on SPY has implied volatility of 16.54%. As a standard sanity check on these numbers, I adjust the forward volatility for the S&P 500 in my Monte Carlo model (Quantext Portfolio Planner) to match the 16.54% implied volatility for the SPY put. The model then generates a projected volatility and expected total return for BWP. The Monte Carlo projected volatility for BWP is 25%, quite close to the 28.7% implied volatility. This gives me some comfort that the BWP's volatility is being priced rationally by the market. In addition, in my analysis of BWP from May 2012, the at-the-money put implied volatility was 25%. BWP is volatile, but the estimates of volatility are consistent.
As I have noted in other discussions, I prefer to use the put option implied volatility for risk estimates since this is the best estimate of downside risk.
While the Monte Carlo estimates of expected total return are highly approximate, it is notable that the projected total return for BWP is 12.5% which aligns quite well with the estimates for total return that can be achieved from the sum of distributions and call premium. This is a very approximate sanity check, but it suggests that the income available here is not violating gravity.
So, we have an estimated total income from BWP of at least 12.7% as long as BWP can maintain its distributions and a projected volatility of between 25% (Monte Carlo estimate) and 28.7% (put implied volatility).
Since its launch in late 2005, BWP has consistently maintained and raised its distributions. Certainly that can change, but a consistent track record is good.
Not least because of the drop in MLP prices during the taper tantrum, it is notable that the five-year correlation between 10-year Treasury yield and the returns from BWP is +29%. This suggests that BWP has historically tended to be somewhat positively responsive to upward moves in Treasury yield and vice versa.
For the income investor seeking a boost from a higher risk / higher yield investment, a covered call strategy with BWP looks quite attractive.