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By Maria Halmo

The search for yield has led many adventurers into our fertile lands. With Treasury rates still floating around 2%-3%, novice and veteran investors alike have turned to MLPs to fortify their portfolios. For many, the chase for yield has turned into a hunt for growth, but some investors are still singularly focused on finding the highest-yielding stocks out there. In our experience, we find that MLPs, just like traditional stocks, can have high yields for a reason—investors are paid to take on the additional risk of those companies. So at what point do the risks outweigh the benefits? How could you possibly go wrong with a stock paying out a 10% yield? Like many things in life, it’s all about balance.

This month’s research spotlight focuses on the dispersion of returns between the highest-yielding names in the sector and the lowest-yielding names. For this analysis, we used the companies in the Alerian MLP Equal Weight Index (AMZE). This ensures that the most investable MLPs are represented, across all subsectors, while excluding those MLPs with variable distributions, or that do not pay a distribution [1] at all. At the beginning of each year, the 50 constituents are ranked by indicative yield and divided into quintiles, such that each quintile basket has 10 names [2]. These baskets are then equally weighted and rebalanced at the beginning of each year.

Basket 1 includes the names with the ten highest yields. Basket 5 has the names with the ten lowest yields. The ten years of historical performance, inclusive of 2004-2013, are then analyzed for price return. Note that the aggregate performance of the baskets may not line up exactly with the performance of the AMZE, since the baskets are rebalanced annually instead of quarterly.

The highest-yielding names are considered to be the riskiest, and that appears to be rewarded, especially during the volatile years of the financial crisis and subsequent recovery. In 2008, Basket 1 fell only a few percentage points more than the index; however, in 2009, during the recovery, it had the highest return: 123%, compared to the AMZE’s increase of 80%.

During the 2008-2009 period, Baskets 1, 2, and 3 regained all of their losses and then some. Baskets 4 and 5, on the other hand, remained down over 20% and 50%, respectively. During volatile times, it appears that the "safest" [3] MLPs, focusing solely on price performance, may not actually provide much safety at all.

In a price return comparison against the five baskets, the AMZE falls in the middle, as is to be expected. Perhaps less intuitive is that the best performer over the period is Basket 2. In the next part of this series, we’ll examine the performance of each quintile and take a closer look at volatility. Stay tuned!

Footnotes:

[1] This is in accordance with the AMZE methodology guide. Variable distribution MLPs typically pay out all available cash, but unlike traditional MLPs, they have no mandate to maintain or steadily increase that distribution. Due to the fluctuations in their underlying cash flow, their yields can swing dramatically from quarter to quarter. For this reason, they’ve been excluded from this study.

MLPs such as SGU, SGH, and RVEP were grandfathered into the index for a period, even after they had ceased to pay a distribution. These MLPs are still included in the study for the length of time they remained in the AMZE.

[2] Pre-2006, there were not 50 MLPs trading on the market. When the number of MLPs is not evenly divisible by five, it is the baskets in the middle that take fewer names.

[3] Safety is an exceptionally subjective term. Here, we use it to refer to the lower-yielding names, because lower yields can imply higher growth, which may carry investors through tough times. Others would argue that in volatile times, higher-yielding names are safer because of the cost of shorting them, as well as the higher income they provide to offset declines in price.

Disclosure: © Alerian 2014. All rights reserved. This material is reproduced with the prior consent of Alerian. It is provided as general information only and should not be taken as investment advice. Employees of Alerian are prohibited from owning individual MLPs. For more information on Alerian and to see our full disclaimer, visit http://www.alerian.com/disclaimers.

Source: Research Spotlight: High-Yield Performance, Part 1