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MLPs have had two outstanding years coming off the lows in November 2008. Below is a brief history of the Alerian MLP Index and yields:

Dec 31, 2006___282___6.4%
Jul 13, 2007____342___5.4% Previous record high
Dec 31, 2007___301___6.4%
Nov 20, 2008___154__15.1% Low during the financial crisis
Dec 31, 2008___176__12.1%
Dec 31, 2009___285___7.4%
Nov 09, 2010___365___6.1% New record high
Dec 17, 2010___350___6.4%

At the time of the previous record high, the yield for the index was a record low 5.4% while the yield on the 10 year Treasury bond was 5¼%. The premium spread of the MLP yield over the Treasury rate was just a few basis points, essentially zero. After reaching its peak in 2007 with a record low yield, the low beta index dropped 60 in a few weeks - a rude shock to MLP investors.

2010 has been a very good year for MLPs. Rising prices for MLP units meant that they received more money when units were sold through public offerings. Increased equity is needed by MLPs to borrow more for financing capital expansion programs. Enbridge Energy (NYSE:EEP) had two pipeline spills and they were repaired. Atlas Pipeline (NYSE:APL), Breitburn Energy (NASDAQ:BBEP) and Crosstex Energy (XTEX) resumed paying distributions (offering yields of 6-8%) after distributions were dropped during the financial crisis. However, Constellation Energy (CEP) is still struggling to increase its distributable cash flow and pay off borrowings so that it can resume paying distributions. Its units have been stuck near $3 while unit holders wait for a resumption of distributions. A number of closed end funds were started to track the Alerian MLP Index and other funds concentrated on MLPs, increasing demand for MLP units.

MLPs may have a difficult time making 2011 a third consecutive winning year after the index doubled from the year-end value in 2008 to record levels. The comparable index including reinvested income has risen from 428 to 991 currently, one of the best runs in history for any index! But yields on the index have dropped sharply to 6.4%, not far from its lowest levels. The spread over the 10 year Treasury bond (added reward for investors to compensate for the added risk of owning a security with business risk) has been reduced to 300 basis points, low in recent times.

Low yields and yield spreads suggest unit prices need a correction. The value for MLPs comes primarily from rewarding investors with current income. Even at today's values, a 6+% yield goes a long way toward earning a target annual rate of return of (let's say) 10%. If the index rises another 19%, the yield at 417 would fall to 5.4% (its prior low in 2007) with the premium over the 10 year Treasury falling to 200 basis points (assuming the Treasury yield does not rise further).

I learned from a friend, who measured the performance of money managers, that after a manager had two excellent years, the third year had a high probability of being disappointing. The analogy may not be perfect, but I see a connection to the performance of the MLP index. Extending the gains from the last two years can not continue indefinitely. But any pause in rapid gains for MLPs should be viewed as bringing more attractive buying opportunities with higher yields. The Alerian MLP Index including reinvested income has grown 10 times in 15 years, equivalent to a 16.5% annual compounded growth rate. Over the same time span it is difficult to find another investment with a comparable rate of growth.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.