Tortoise Energy Capital: An Attractive CEF That Owns MLPs

Sep.20.11 | About: Tortoise Energy (TYY)

Master Limited Partnerships (MLPs) have been one of the best performing asset classes over the last decade, especially on a risk-adjusted basis. The Sharpe ratio for MLPs has been consistently higher than for other asset classes.

There are several ways to own MLPs. You can buy the individual issues, or purchase closed-end funds, ETFs and ETNs.

There are many tax considerations to take into account when you purchase energy related MLPs. I generally recommend owning individual MLPs in taxable accounts, but prefer to own MLP closed-end funds in tax deferred retirement accounts.

If you directly purchase an MLP, you will receive a K-1, and may be subject to unrelated business taxable income (UBTI). You may also need to file tax returns in several states.

Here are some of the key characteristics of closed-end funds that own MLPs:

  1. You will receive one Form 1099 per shareholder instead of multiple K-1 forms.
  2. Nearly all MLP closed-end funds are organized using a C-corp structure, not the usual registered investment company (RIC). CEFs are not structured as RICs because no more than 25% of an RIC can be invested in MLP securities (American Job Creation Act of 2004). There was one RIC closed-end fund, TYW, that limited their MLP exposure to 25%, but it recently announced that it will be open-ending.
  3. MLP CEF dividends are considered qualified dividend income (QDI) and a portion of the dividends are normally classified as return-of-capital.
  4. MLP CEF shares do not generate unrelated business taxable income (UBTI) or state taxes in IRAs.
  5. MLP CEFs normally use leverage.

Most CEF web sites report the majority of MLP closed-end funds trading at significant premiums over net asset value. But this is quite misleading. Many MLP CEFs have deferred tax liabilities (DTLs) which I believe should be added back NAV to make the numbers more comparable with other closed-end funds that are organized as registered investment companies.

MLP CEFs that are organized as a corporation must book a deferred tax liability (DTL) against securities in their portfolio that have appreciated. (When securities depreciate in value, a deferred tax asset (DTA) occurs.) As portfolio values change, DTLs or DTAs will occur. But since MLPs have generally had strong asset performance since inception, most MLP CEFs that have been in existence for some time have generated significant DTLs.

DTAs and DTLs do not adversely affect the value of the fund’s underlying investments, and are really no different than having unrealized capital gains or losses in a traditional closed-end fund. The deferred tax liability only affects “real” net asset value when there is a sale of the investment that generated the DTL.

For CEFs with a low turnover ratio, I use an “adjusted” NAV where you add back the deferred tax liability (DTL) to the reported NAV. After this adjustment is made, many MLP closed-end funds sell at attractive discounts to NAV.

Tortoise EnergyCapital Corp (NYSE:TYY) is a closed-end fund designed to provide an efficient vehicle to invest in a portfolio of publicly-traded master limited partnerships (MLPs). It seeks to obtain a high level of total return with an emphasis on paying current distributions to shareholders.

Under normal circumstances, the fund invests at least 80% of total assets in equity securities of energy companies and at least 80% in equity securities of MLPs in the energy infrastructure sector. Up to 50% of total assets can be in restricted securities, primarily through private placements. The fund may invest up to 20% in debt securities. This is the sector allocation as of May 31, 2011:

TYY- Sector Allocation Breakdown

Crude/Refined Product Pipelines

40.0%

Natural Gas/Natural Gas Liquid Pipelines

38.2%

Natural Gas Gathering/Processing

18.9%

Propane Distribution

2.9%

Click to enlarge

TYY has good long term NAV performance but with a lot of volatility. The one losing year was 2008 when the NAV lost 53.2%. Over the 5 years, it has produced a 7.13% annualized return based on NAV. The five year return based on market price was 9.38% annualized. Here is the total return NAV full year performance for TYY since 2006:

2006

+27.96%

2007

+7.50%

2008

-53.19%

2009

+96.07%

2010

+30.67%

YTD

-1.09%

Click to enlarge

TYY- Top 10 Equity Holdings (as of Aug. 31, 2011)

EPD

6.8%

ETP

6.6%

EEP

6.4%

SXL

6.3%

KMR

6.1%

EPB

5.3%

BPL

5.3%

RGP

5.0%

PAA

4.6%

MMP

4.5%

Click to enlarge

Here are some summary statistics on TYY:

  • Total Assets: 673.2 Million Total Common assets: 464.8 Million
  • Inception Date: May 31, 2005
  • Annual Distribution (Market) Rate= 6.47%
  • Last Regular Quarterly Distribution= $0.4025 (Annual= $1.61)

(Note: The quarterly dividend was recently raised from $0.40)

  • Fund Expense ratio: 1.72% (Management Fee= 0.95% on total assets)
  • Premium over NAV= +3.88% (before DTL adjustment)
  • Deferred Tax Liability (DTL)= 6.08
  • Adjusted Discount to NAV= -17.1% (after adding DTL to NAV)
  • Portfolio Turnover rate: 13%
  • Effective Leverage: 30.96%
  • Average Daily Volume (shares)= 59,000
  • Average Dollar Volume = $1.57 Million

As of the end of August, the CEF asset coverage ratio for preferreds was 397% where the minimum requirement is 200%. For debt, the asset coverage ratio was 577%, where only 300% is required.

TYY is reasonably liquid for smaller investments, but care must be used for larger purchases. The official NAV for TYY is only updated weekly by the fund, but approximations to the NAV can be made by looking at price changes in the underlying holdings.

The main negative for TYY is the high expense ratio. I believe management is overpaid, given the “buy and hold” nature of the underlying portfolio. But because of the attractive adjusted discount to NAV, TYY can still be a convenient way to own MLPs in an IRA when it has a price dip.

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