The Added Risk From MLPs' Recent Run

|
 |  Includes: AMJ, EPD, MLPG, MLPI, MLPL
by: Avi Morris

MLPS are having an incredible year following 2009, their best year in history. The Alerian MLP Index (AMZ) is up 14% YTD plus two distributions that were paid representing half of a 7.4% yield at the start of the year. Such gains would be excellent in a year, but this was done in just over half a year. The comparable index including reinvested income, AMZX, has been at record levels for most of the year. Meanwhile popular stock averages are lower YTD and off significantly from recent record highs. MLP Index data is presented along with the record date in 2007:

.....................AMZ...AMZX.....yield

Jul 13, 2007___342___750----5.37%
Dec 31, 2009__285___755----7.4%
Jul 16, 2010__324__888---6.7%

But I have difficulty understanding what is causing so much MLP buying in a mundane year for the stock markets. There have not been dramatic changes for MLPs or their business model. Ample financing is available for large capital programs as has been the case in this decade. However one key difference is new tracking funds and mutual funds for MLPs, money buying MLP units. This has helped most MLPs reach record or near record levels only 18 months after the index was in the 150s with fears the index could fall to its starting value of 100 at the end of 1995.

For the time being a powerful freight engine is pulling the MLP train and it looks like nothing can stop it. But the yield is important for new buyers, when yields on MLPs decline they are less desirable. The only time periods when the index yield fell below 6% was in the middle of 2005 and the middle of 2007 (reaching its all time low of 5.37%). At that time, the yield spread (premium over the yield on the 10-year Treasury bond) was just a few basis points (near zero). Today's yield spread is 375 points, partially related to the Treasury bond's abnormally low yield under 3%. Traditionally a 200-point spread was considered ordinary, but after the price plunge in late 2008 larger spreads are accepted.

Earnings season just began with Enterprise Products (NYSE:EPD), the largest MLP, increasing its Q3 distribution to 57-1.2 cents per unit ($2.30 annualized), a 5.5% increase over Q2. This is its 33rd distribution increase since the IPO in 1998 and the 24th consecutive quarterly increase. Other MLPs are also declaring quarter over quarter increases. But declining yields from higher prices haunt me. At a new record level of 343, the yield will decline to 6.3% and the spread could decline to around 300 basis points. Such a yield may signal a significant reversal is coming.

Disclosure: No positions