Infrastructure master limited partnerships, or MLPs, have had a tremendous performance in the first half of 2014. The Alerian MLP ETF (NYSEARCA:AMLP) is up 9% year-to-date, while the corresponding ETNs, JPMorgan Alerian MLP Index ETN (NYSEARCA:AMJ) and UBS E-TRACS Alerian MLP Infrastructure ETN (NYSEARCA:MLPI), which track the same index, are up 16%*. (*Please see the Appendix for the differences between MLP ETFs and ETNs). Readers familiar with my "Buy-the-dip High-Yield" portfolio know that the 2X leveraged UBS E-TRACS 2x Long Alerian MLP Infrastructure ETN (NYSEARCA:MLPL) is one of my main holdings, and investors in this ETN are sitting pretty with a 31% gain so far this year.
However, have infrastructure MLP valuations risen too far, too fast? In a recent article entitled "Is It A Good Time To Buy MLPs?", Seeking Alpha contributor Factoids presents the case that MLPs are overvalued based on their current yields and P/DCF, while at the same time not overvalued based on other metrics such as spread over 10-year treasuries and spreads to high-yield bonds.
Certainly, no investor can be faulted for taking gains in infrastructure MLP funds at this point, as their 1H 2014 performance represents up to three times (for AMJ) their annual payout. On an annualized basis, one could be locking in up to six times the annual yield of the MLP funds by selling now. On the other hand, MLPs still possess favorable tailwinds due to the ongoing energy revolution in the US, and investors who prefer to "let winners run" might hope for the momentum in MLPs to continue for at least the next six months.
For those considering buying or holding MLP funds, this article highlights an opportunity in a CEF that, in my view, represents a significant value investment worthy of further attention from investors.
KYN Historical Outperformance
The Kayne Anderson MLP Investment (NYSE:KYN) CEF has been one of the best performing CEFs in recent years. According to CEFconnect, KYN has outperformed sector CEFs since inception as well as on 5-year and 3-year bases, while only underperforming by less than 1 percentage point on a 1-year basis.
Notably, KYN has done very well versus the index ETF since the latter's inception in August 2010. The following table presents the NAV performance of KYN and AMLP in the three complete calendar years since the inception of AMLP. Data are sourced from Morningstar.
|AMLP||KYN||KYN (without leverage)^||AMJ*|
^Calculated by dividing the return of KYN by the leverage ratio of 1.3, since KYN employs a leverage percentage of 30%.
(*The total return for the Alerian MLP Index ETN is shown for comparison. However, due to tax considerations, KYN should be benchmarked against AMLP and not AMJ. See the Appendix for details.)
The table above shows that KYN has soundly beaten the index ETF over the past three years, even when the 30% leverage ratio of KYN is accounted for. Moreover, data from the Kayne Anderson website shows that KYN has achieved 12.5% annual returns from inception in 2004 (9.6% without leverage). This period includes the bear market of 2007-2008, which saw KYN lose over half of its net asset value.
This outperformance can help to explain why KYN has persistently traded at a premium over the past five years, despite its listed expense ratio of 2.6%*. (*The true expense ratio may be higher as a result of tax consequences of MLPs. See Appendix for details). According to CEFconnect, KYN has maintained an average premium of 9%+ over the past five years.
Recent discount in KYN brings opportunity
Given its strong track record, KYN's price performance in 2014 has been surprisingly lackluster relative to broader sector. Despite KYN's use of 30% leverage, it has managed only a measly 2.0% price gain year-to-date. The graph below shows that the KYN:AMLP uptrend, which had been in place for at least 2-years, had been broken since the start of 2014.
On closer inspection, we see that this underperformance in the share price of KYN is nearly all due to the shrinking premium of the fund. The underlying NAV performance of KYN year-to-date is 16%, putting it way ahead of the index ETF AMLP, which has recorded a 9% return under the same period. In fact, the current valuation of KYN has reached discount territory (based on the latest NAV/price figures published by Kayne Anderson on 7/3), which is something that has not been seen since early 2009. The below chart is from CEFconnect.
In an excellent article published earlier this year, Seeking Alpha contributor Morgan Myrmo called KYN the "Best MLP Fund in the Universe." As an example of the superior management of KYN, Mr. Myrmo uncovered the fact that Kayne Anderson managers were heavily underweight in Boardwalk Pipeline Partners (NYSE:BWP), and thus largely avoided the disaster in the stock in Feb 2014 when the distribution was cut. He concludes:
When it comes down to it, there is a reason that investors are paying a premium for KYN. Due to industry dominance, top management, the top MLP investment/research team, fund size and historical performance KYN is arguably the best diversified MLP fund in existence.
In addition to this, due to a short-term divergence from historical premium levels KYN is a compelling buy. Long-term income investors, as well as MLP investors, would be smart to take advantage of market timing to purchase KYN over the next two trading days.
Readers are encouraged to read Mr. Myrmo's excellent article for further facts and details regarding the investment case for KYN. This article deals rather with the current valuation of KYN, which in my opinion, is severely depressed. Note that Mr. Myrmo's article was published when the premium of KYN had shrunk from its historical 5-year average of 9+% to 5.2%, its value in February. The premium has now completely evaporated and has instead reversed to a slight discount. This is a premium/discount differential of 9% from its 5-year historical value. This means that if KYN were to revert to its historical premium value, investors would gain 9% from this feature alone, in addition to distribution and capital appreciation (or losses). When considering only its discount value, KYN is a very compelling buy.
A possible rotation strategy
While KYN is a "buy" based on its discount value, the strong run-up in infrastructure MLP prices in 2014 suggests caution. As we all know, valuations are one of most reliable predictors of future returns. Could the expanding discounts in KYN and other CEFs be a sign that investors are getting more pessimistic about the future outlook for MLPs? To be honest, I don't know, and I would welcome investors' viewpoints regarding their future for this asset class.
However, there is one way to take advantage of the discount of KYN without committing to a directional bet on the outlook for MLPs. That is to trim existing holdings in MLP index funds or individual stocks, while buying KYN. Another option is to short AMLP (as the closest index proxy to KYN), but this should only be attempted by experienced traders due to the requirements for margin trading and the need to pay short interest expenses.
Around two weeks ago, I published an article regarding a possible rotation strategy for two Eaton Vance option-income funds (sell ETW and buy EXG), based on an anticipated reversion of discount differences. Happily, the trade is working in my favor and has achieved a gain of about 2% so far.
Similarly, regardless of the future outlook for MLPs, I expect KYN to revert from its present discount to a significant premium. Therefore, the simple recommendation of this article is to sell AMLP and buy KYN. Personally, I am adding to my KYN holdings while trimming from MLPL.
At the time of writing, KYN manages 4.2B in common assets and trades 250K shares a day. KYN is by far the largest player in the MLP CEF space, and is nearly 80% larger than its nearest competitor in terms of asset size, Tortoise Energy Infrastructure (NYSE:TYG), which manages 2.4B in common assets and trades 50K shares a day. By comparison, AMLP holds 9.1B in assets and trades 3.2M shares a day while AMJ holds 6.6B in assets and trades 600K shares a day. Therefore, investors in KYN should not be too worried about the lack of scale or liquidity in KYN.
KYN pays a 6.4% distribution quarterly. Its distribution has been steadily rising in the past two years, with a two-year DGR of about 10%. By comparison, AMLP pays a 5.8% distribution and AMJ pays a 4.4% distribution. The chart below shows the historical distribution payout for KYN and is from CEFconnect.
KYN is run by a top-quality management team, and its strong track record is deserving of its persistently high premium of 9+% over the past five years. Therefore, the current slight discount, which has not been seen since 2009, represents a compelling bargain for investors. On the other hand, the strong performance of infrastructure MLPs in 1H 2014 may be expected to temper future gains in this asset class. Hence, investors unwilling to make a directional bet on MLPs but who believe in KYN's management and also wish to take advantage of the mean-reverting tendencies of CEFs could do so by buying KYN and selling the index MLP ETF, AMLP.
The below chart shows the 1-year price action for KYN. Notice how KYN is trading barely above its price at the start of 2014 (meanwhile, its underlying NAV has appreciated by 16%!). Contrast this with the 1-year chart of AMLP shown at the start of this article.
Disclaimer: I am not a tax expert so the discussion that follows is based on my own understanding.
Due to tax considerations, MLP ETFs/CEFs are treated very differently than ETNs, more so than for other asset classes. According to Seeking Alpha contributor Ron Rowland, the taxation policy favors the ETN over the ETF when the value of the MLPs are rising, while the opposite is true for falling MLP prices. The taxation issue can have a significant effect on the total return of the funds. Mr. Rowland calculated a 6.3% annual differential in the total returns of AMJ over AMLP from 2010 to 2013. Furthermore, Mr. Rowland has estimated the deferred income tax expenses to be 7.59% since the inception of AMLP.
Further details on the differences between MLP ETNs and ETFs can be found in The Definitive Guide To MLP ETFs And ETNs. Quoting from the article:
Broadly speaking, an ETN makes most sense for MLP exposure if:
* The investor expects the majority of total return to come from price appreciation.
* The investor is using a tax-deferred account and cannot benefit from the tax deferral of the ETF structure.
* The investor has a shorter time horizon.
* The investor places a high value on transparency and predictable returns.
* The investor is unconcerned about the credit risk of the note.
* The investor is more concerned with total return than after-tax yield.
An ETF/corporation makes most sense for MLP exposure if:
* The distribution yield of the MLP is greater than or equal to the MLP index total return. In this case, the tax-deferral overwhelms the performance hit of the internal tax issues; however, paying out a higher distribution than total return is likely unsustainable in the long run.
* The investor has a very long time horizon, including potentially passing her position to an estate.
* The investor uses a high discount rate to value future cash flows.
* The investor has a low tolerance for credit risk.
* The investor is comfortable with complex tax accounting and its associated risks.
* The investor values tax efficiency over absolute returns or index tracking.
Disclosure: The author is long KYN, MLPL, NML. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.