Co-written by Kristina Maestas
This week in MarketWatch, I was interviewed about the shortsightedness of investors who are fleeing bonds. I want to expand on one of my ideas in more detail, specifically about Master Limited Partnerships (MLPs) as alternatives to high yield ETFs. The MarketWatch interview is about people wanting to exit the bond markets for other more risky assets, and I warn people to budget their risk. Some investors have kept bond allocations, but in order to chase yield have been increasing the risk in their bond portfolio. We want to look at a possible alternative to substitute that high-risk bond part of your portfolio with something that still has a similar level of risk, but does not have the same interest rate risk as junk bonds. If we can do that and lower the correlation, we've got a hold of something big. But with this enthusiasm comes the realization that many investors have already painted themselves into a corner and need an exit strategy.
Before we get into the nature of MLPs, which is now a well-covered, little-known asset class, it is important to state clearly the strategy we are fleshing out. This isn’t about trading your high quality corporate bonds or treasuries to jump into midstream pipelines. That is one risk substituted for a higher risk. Only until we get into the land of equity like risk (junk bonds or preferred stocks) do we have a common ground to swap junk with MLPs. While it should be a no-brainer to diversify into what we will show later is a lower correlating asset class, the prevailing winds of bond anxiety should not blind an investor into mixing metaphors. What we find most appropriate is a swap for those people who have a small allocation to junk bonds or have found themselves over-allocated to junk due to greed and stupidity. Stupid happens sometimes and I want to suggest some ways to mitigate a bad situation using a correlation substitution like methadone for a junkie. Nobody said investing was clean and easy.
Bonds have been in a bull market since 1981. After a 30-year run it could go on, but don’t you think that is a bit long in the tooth? We thought inflation and bond declines would have happened by now. One of the primary reasons for including bonds in a portfolio is diversification with cash flow. It is the whole return of your capital argument, which is valid and important no matter what risk you want to take on. However, what if you are starting to question the rate environment and noticed your high-risk junk bonds may lead your potential losses? MLPs are neither stocks nor bonds, but they can be an alternative to a portfolio seeking diversification and income outside of traditional asset classes. If you were thinking of buying (or have already bought) higher volatility bond ETFs like HYG, JNK and/or PFD, read on and find an alternative strategy to capture higher risk return with lower correlation to stock and bond markets.
MLPs pass through their income to limited partners, so they don’t pay corporate tax; thus, there's no double taxation. Plus they tend to be pipelines, so they’re more like a utility or a toll road. Due to this tax structure, many institutional players don’t buy MLPs. Also, the market is tiny compared to bonds or equities. These last two items contribute to an inefficient market that investors can still profit from; just know that more people are aware of MLPs now, so all bets are off as to how much this open secret will remain attractive. What could go wrong? There could be more correlation in the future to either stocks or bonds.
This is all fine and dandy, but how long will it last -- and why don’t more people use MLPs? One reason is the complicated tax structure. For every MLP that you own, a separate K-1 will arrive in your mailbox each year. For the smaller investor, this is a nightmare that is hardly worth the trouble, and less of a headache for IRAs. At this point you have a couple of options. You could purchase a slew of MLPs to manage risk; then again, you could also purchase 500 stocks rather than buy an S&P 500 ETF. Take my word for it: It is not pleasant to call the investor relations department of a small MLP and have them correct information or reissue you another K-1 for your 1,000 shares. On top of that, what if you are actively managing position size to account for risk, change in volatility, and general rebalancing? In short, while possible, you’re asking for a disaster. The other option you have is to seek ETNs that track indexes of MLPs. J.P. Morgan Chase’s Alerian MLP Index (AMJ) is the most popular and liquid offering at this time. You get the diversification within the asset class you’re looking for and a single 1099 come tax season.
AMJ Correlation with Other Asset Classes
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The top question I get from investors is why they wouldn’t put all of their money into MLPs. On the surface they look great, almost like a bulletproof utility with a strong dividend. However, nothing is a sure thing, and the money paid out is simply based on the cash flow the firm collects. This could change with competition in the industry and government regulation. We love the group and hold a lot of it, but we are ready to blow out of the asset class at the first sign of trouble. Beware of correlation to other asset classes, and don’t get carried away. In 2008 we saw that the group could get killed with the rest of the world.