MLPs Offer Steady Income And Exposure to Shale Gas Development

Dec.16.11 | About: Kinder Morgan (KMP)

By Simon Lack

The New York Times today has a piece on Richard Kinder, founder of Kinder Morgan (NYSE:KMP), the largest publicly traded partnership in the U.S. KMP recently agreed to acquire El Paso Corporation to create an entity controlling 80,000 miles of pipeline crisscrossing the U.S. KMP is a Master Limited Partnership (MLP), which is to say that owners of LP units (as their shares are known) own a proportional stake in the underlying assets rather than shares in a corporation. The big advantage of this structure is that there is no 35% corporate income tax, so the profits flow straight through to the unitholders without the double taxation that occurs when corporations use after tax profits to pay dividends that are themselves taxable.

MLPs, and KMP in particular, also represent an investment in the growth of natural gas as a source of America's energy production. Cheap shale gas is increasingly being used to produce residential electricity. From 2005-2010 consumption for this purpose grew from 5.9TCFE (Trillion Cubic Feet Equivalent) to 7.4TCFE, more than 70% of the increase in total natural consumption to 24TCFE last year (according to the EIA). A shifting mix of energy sources requires new infrastructure to transport, store and refine it, which is what KMP recognizes. JPMorgan initiated coverage on the sector in October and expects $130BN in infrastructure spending over the next 10 years.

KMP pays a $4.64 distribution, giving a current yield of 5.9%. They've grown this distribution at a compound annual rate of 14%. This is high for an MLP, but 6% annual distributions with likely growth of 4-6% over the next 2-3 years is a reasonable assumption, offering the potential for 10-12% total return (assuming multiples are unchanged). Distributions are also largely tax-deferred, since much of the cash received by unitholders is classified on their K-1 as a return of capital, rather than income. Ah yes, you have to deal with a K-1 instead of a 1099. They're not for everybody, and unless you use a tax accountant and can afford to invest at least $250K in a diversified portfolio of individual names this sector is probably not for you.

But for high net worth investors interested in a 6% tax deferred distribution yield with likely 4-6% growth and tolerant of K-1s, this is a sector that belongs in most portfolios. In fact, I think MLPs are a great substitute for high yield bonds. They exhibit similar levels of price volatility (in a weak equity market they can fall farther than you'd like) but offer better return prospects. While unitholders do own equity interests, the overall risk/return characteristics are more bond-like than equity-like.

MLPs are putting in another solid year, with the Alerian MLP Index returning 7.7% for the year through November. That's ahead of both high-grade bonds (the Dow Jones Corporate Bond Index is +6%) and the S&P 500 (+1.1%) over the same period.

Government policy is to transfer real wealth from savers to borrowers. Policy rates and bond yields are being maintained at levels so low that, after taxes and inflation savers are virtually guaranteed to lose purchasing power. Bonds have their place in a portfolio, and no doubt there are plenty of issues facing markets right now starting with the Eurozone. But given the guaranteed poor long-term outlook for bonds, we think investors should be reducing their overall fixed income weighting in favor of alternative sources of income (such as MLPs) and dividend paying stocks.

Retail investors have been steadily increasing their holdings of corporate debt. For example, the iShares iBoxx Investment Grade Corporate Bond Fund (NYSEARCA:LQD) has seen steady growth in outstandings all year. Corporate bonds have been strong performers for the past couple of years, but with yields on high grade bonds currently around 4%, you can only make 4% and after 2.5% inflation there's about enough to pay taxes and that's it. The Federal Reserve is causing this distortion in the fixed income markets. They can keep it up for a long time.

Today's fixed income investors are competing with the world's deepest pocket - it's probably time to look elsewhere.

Disclosure: I am long KMP.