Attractive Outlook for MLPs Following September Lows

by: Avi Morris

The large decline for MLPs in the last year is bringing attractive prices for long term investment.

In the middle of last year, the Alerian MLP Index was concluding a beautiful 9 month run, rising from 260s to record levels in the 330s. This was followed by a couple months of sideways trading to an all time high of 342 in July. Then came a dramatic fall, taking the index down 60 points in just 3 weeks (the start of the credit crunch period) as some hedge funds & hot money funds liquidated investments quickly. Buyers returned, bidding the index up over 300. For the next 12 months the index kept slipping lower, to the 290s, then 280s, then 270s and to the 260s by August 2008, reaching 2 year lows. Considering the declining stock market during this period, this performance was not that bad.

Then came September. September is statistically the worst month in the stock market as this year turned out to be. When the stock market sold off, the index was caught up with the selling pressure. It started the month at 271, after a slight recovery at the end of August, by dropping 60 points to a new low close of 221. There were 3 days with 4+% declines, another 2 with 2+% declines along with one big gainer day of 8%. MLPs are noted for their low beta stocks (really units) but that concept was put to the test. Even after a modest recovery last week, the index remains down 40 points making September one of its worst months ever. That decline may have been aggravated by the demise of Lehman as they were heavy into MLPs which resulted in forced liquidations at reduced prices.

Important for evaluating MLPs are yields. The current yield for the index is 8.7%, last seen 8 years ago. Another key measure is the yield spread over the Treasury 10 year bond which is a hefty 500 basis points, the traditional spread is 200 basis points. By way of contrast, last year when the index was near its high, Treasury bond prices declined sharply raising the yield to 5¼%, narrowing the spread to only a few basis points. A very large spread should be a signal of good value.

The long term track record for the Alerian MLP index is excellent:

Alerian MLP Index

  • 12/31/95....100
  • 9/25/08....239
  • 9/25/08....567 (including reinvested income)

Those who reinvested income profited during a period which is highlighted by a very large market decline at the start of this decade. The decline in recent months has hurt the 2 index numbers on fears of the unknown. The large yield spread is similar to an even larger spread between the Treasury rate versus yields on junk bond funds (over 1200 basis points).

When there is strong demand for higher quality investments, lower quality investments suffer. For investors who can tolerate a little additional risk, high yields on MLPs provide excellent rewards. For example, a 9% yield is a great start when the objective is to obtain a 10% annual total gain. However, there are worries about additional liquidations in the next few weeks which would produce even more attractive (lower) prices and higher yields. The long term investor can set target purchase prices in an industry with strong long term fundamentals.

The outlook for the industry remains excellent. They will keep building more pipelines to expand the country's ability to move oil and gas. Large capital expenditures are necessary so companies can keep the tax advantage on their distributions.

Author's note: The above article was written last weekend, prior to ugly Monday in the stock market followed by the Tuesday-Wednesday recovery. Fundamental points for MLPs remain, the long term outlook is excellent. Building more pipelines is a national priority, the reason for generous tax benefits available on these investments. There may be big bumps the over short term, as seen in recent market behavior. However, more bumps in the road (a kind way of describing downward drafts) from liquidations by hedge (and other) funds will create buying opportunities for shrewd investors.