Some Possible Logic Behind The KMR-KMP Yield Spread

Includes: EEP, EEQ, KMP, KMR
by: Mister Minor

While KMR and KMP have both proved to be highly lucrative investments for unit-holders, the persistent yield/price spread between the two has led some to suggest KMR is a better value, and even further that this spread should eventually close, implying greater potential upside for KMR.

A bit of background. KMP and KMR represent partnership units in Kinder Morgan Energy Partners. KMP is a traditional MLP vehicle (meaning you get a K-1 come tax time) that pays cash "distributions" to individuals. KMR is identical in ownership rights and distribution amounts to KMP, except it is structured as an "I-share," which pays distributions as fractional shares - in other words, KMR DRIPs for you automatically. KMR unit-holders do not receive K-1 forms, and KMR shares are better suited for some retirement accounts.

Now to the question at hand. In theory, KMR and KMP should trade at par, yet there has been a consistent undervaluation of KMR by the market, and thus greater yields. Why? As noted by other articles (for instance, here and here), Kinder Morgan management and other experts believe this phenomenon to be a mistake by the market. Some mildly plausible hypotheses include the possibility that dividend stock screeners are missing the yield on KMR, due to the way in which distributions are allocated (via fractional shares), or that there is something inherent about the value of cash vs. shares, even if many KMP investors do DRIP (as I do). Other authors have suggested this latter point makes no sense, as one can easily make KMR an income source identical to KMP by simply selling shares as they come in.

This is where I believe there may be justification for the spread. KMP and other MLPs are known as excellent income stocks, due to their relatively high yields and favorable tax treatment. Specifically, distributions from MLPs are, in general, not taxable, but instead lower the cost basis of the original investment (this can get tricky when reinvesting, but KMP does the calculations for you in the K-1 package). This structure is especially attractive for older investors who are looking for a steady income stream, but also plan on bequeathing their investments, as the cost basis on investments resets upon death. At current yields for KMP, a rough estimate concludes that an individual can count on about 16 years of tax free income before the cost basis on the original investment drops below zero and distributions begin to be taxed at ordinary income rates (this does not account for distribution growth, and so the period may be considerably shorter).

This is where the major difference between KMR and KMP becomes apparent. As noted by Kinder Morgan here,

Under IRC §305(a), stock dividends of Kinder Morgan Management, LLC are not taxable upon receipt to the stockholder. However, the stock dividend does affect the basis of each individual unit held by the stockholder. Under IRC §307(a), the basis of such new stock and of the stock to which it is distributed (referred to as old stock), respectively, shall, in the shareholder's hands, be determined by allocating between the old stock and new stock the adjusted basis of the old stock.

Whereas KMP distributions lower the cost basis of your principal by an equivalent amount (and DRIPS are assigned to subsequent lots, which are in turn subject to cost-basis adjustment), KMR distributions are immediately equalized with the principle. This means that it is not possible to enjoy a tax free income stream until the zero-cost basis limit is reached by using KMR. Instead, the tax liability will increase as distributions accrue. For instance, if 100 shares of XYZ partnership units were purchased with a 10% annual yield, an investor would benefit from 10 years of tax free income before the cost basis turned negative. Alternatively, if 100 shares of XYZ I-share corp were purchased with a 10% annual yield paid via fractional shares, and the "receive-and-sell" strategy were used, after one year those "effective" distributions would be assigned a 9.1% (1-100/110) capital gain, after two they would be assigned an approximately 17% gain, and so on and so forth (this assumes no price change).

In other words, using KMR as an income generating investment forfeits some of the tax deferring benefits of the MLP structure, potentially making KMP more attractive, especially for older investors.

This said, I personally believe the actual cause for the spread is more complicated. For instance, consider Enbridge's MLP and I-share vehicles (EEP and EEQ, respectively), which are showing a spread in the opposite direction. My only hypothesis regarding a possible reason for these differences is through looking at the institutional ownership rates between EEP and KMP, with the latter showing a much lower rate. This tells me that there may be a lot of retail folks in KMP with massive unrealized gains and DRIPs that are both limiting supply and providing a demand base for partnership shares.

Regardless of the causes for the KMR-KMP spread, it is important to discuss these investments with an accountant to determine the best strategy. While KMP does appear relatively expensive when compared to KMR, there may be more to the story.

Disclosure: I am long KMP.