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Last week, I wrote an article going over Kinder Morgan Energy Partner's (NYSE:KMP) guidance, and I found several comments and direct messages point to rising rates as a reason to be concerned about future returns. I feel a need to discuss this concern and why I am still bullish on KMP. (By extension, this article covers Kinder Morgan Management (NYSE:KMR), KMP's sister company that automatically reinvests the dividend for you.) KMP, along with many MLPs, have been dubbed "bond equivalent" investments. Essentially according to this thesis, as bond yields fell, investors who needed yield rotated out of fixed income into higher-yielding, utility-like stocks like KMP, Verizon (NYSE:VZ), Consolidated Edison (NYSE:ED), etc. This theory makes sense, and there is definitely anecdotal evidence that some investors did this (I know some who did). It is worth considering though that since 2008, equity funds have seen net outflows while bond funds saw net inflows.

On the whole, investors had been moving from stocks to bonds, due to fear instilled by the financial crisis. 2013 has finally reversed this trend with money moving back into stocks. Now, it is certainly possible that while money was leaving the market as a whole, it was flowing into certain sectors, like high dividend names. As a consequence according to the bond equivalent theory, when rates rise, investors will sell their equities and move back into safer and now higher yielding treasuries. We have seen a pretty significant rise in yields this year with the 10 year yield moving closer to 3%. I looked at the 2013 chart comparing KMP to treasuries to see if there was any correlation:

(click to enlarge)

Obviously, KMP has held up far better than bonds, but there is a similar pattern. As treasuries fall (meaning their rates rise), KMP on average falls. Are KMP and bonds 100% correlated? Definitely not. Has there been some correlation over the course of the year between the two assets? Yes, there has. Still despite the correlation, investors in KMP would be much happier than those in bonds this year. Interestingly, the longer term picture is far cloudier and suggests a far weaker correlation between bonds and KMP.

(click to enlarge)

Here, you notice a relationship between rates and treasuries. In 2008 and 2009, they were inversely correlated due to the "safe haven" nature of bonds. From 2009 to early 2011, KMP rallied significantly while rates were sideways. Similarly, as rates started to fall in 2011, KMP actually fell before rallying while rates moved sideways. There was a notable lag. KMP's performance has also far exceeded that of treasuries. Simply put, KMP's own fundamentals have mattered and impacted performance beyond any direct bond equivalence trade. The recent stronger correlations has been more of an exception than the role and is far from guaranteed to continue.

Now, this is not to suggest that KMP's unit price will not be impacted by rising rates in 2014 (assuming they do rise, which seems to be consensus). It might be impacted, and it might not be. The future is never known. Rising treasuries mean that the "risk-free" rate of return increases, which decreases the present value of future cash flows, thereby lowering all asset prices. Now investors aren't stupid, and few assets were priced like 1.5% on the 10 year would be sustainable for a protracted period of time. Similarly with an expectation for an increase in rates already baked in, KMP might be not affected if rates hit 3% or 3.25% in 2014. Similarly, rising rates are not necessarily a bad thing for KMP's business. If Kinder Morgan performs better, its units should go up.

Over the past 100 years, ten year treasuries have yielded about nominal GDP (inflation plus real GDP). Right now, that would suggest around 3.5%-4%, depending on how you view the accuracy of CPI. I struggle to see a case for investors rotating out of KMP, which yields 6.75% and grows its payout, and into a 3.5% treasury. Such an action should only be taken by the most risk-averse of investors and even then is a dubious trade.

What happens if treasury yields over the next three years move dramatically beyond 4%? There would be two underlying reasons for this to happen: stronger growth or higher inflation. Let's consider the two options. If GDP growth is stronger, that means there is more demand for energy. Higher demand for energy means higher demand for pipelines, increasing prices and expansion opportunities. Both of those things are great for KMP, will boost profitability, and increase the payout to shareholders. A world where rates rise because GDP is growing more quickly is one where KMP's distribution hike will be greater. If anything, that would be a reason to buy KMP.

Next, many believe that at some point quantitative easing will increase inflation. Higher inflation increases nominal treasury yields. Will this hurt KMP? No, in fact, the opposite is true. Pipeline contracts have inflation hedges embedded within them where payments increase alongside an inflation metric. These contracts often have durations of several years, so inflation is taken into account to ensure that payments stays the same in real terms over time. While inflation could send treasury rates higher, it will also increase KMP's cash flows and thereby its distribution.

Suddenly, I am not so concerned about rising rates; if anything, Kinder Morgan could stand to benefit from rising rates, assuming an increase is rooted in economic reality. I concede that if the bond market goes wild when the Fed tapers and yields jump to 6% or 7% without any change in economic conditions, KMP will suffer because all stocks will. This outcome is just hard to imagine playing out as there is no economic reason for such a move, and the Fed would never let rates move that high without expanding asset purchases as a 6% 10 year would kill the recovery. In 2014, I don't see rates moving much beyond 4%, if that high, and investors would be far better off owning KMP at 6.75% than the 10 year at 4%.

Similarly looking beyond 2014, rising rates can be good for KMP because the fundamentals that would send yields higher will also send KMP's distribution higher. While the discount rate may be higher, future cash flows will be higher too, negating the negative impact. Perhaps, some investors have rotated into KMP as a "bond equivalent," and if they are smart, they will stick with KMP even as rates rise. At 6.75%, KMP offers a fantastic yield that is secure thanks to stable cash flows inherent in long term contracts. With U.S. oil and gas production continuing to grow, KMP will be able to grow its payout by 5-7% through 2020. Just as KMP has far outperformed treasuries over the past decade, I expect it will outperform in the next decade.

I know many investors are worried about rising rates impacting Kinder Morgan Energy Partners. My advice is don't worry. The distribution is far more attractive right now and will grow alongside rates. Perhaps, some investors will wrongly dump KMP for bonds over the next 6 months. If that happens, the long term investor would be wise to add to KMP on the weakness and enjoy far superior long term returns.

Source: Rising Rates Don't Matter For Kinder Morgan Energy Partners