Nervous About MLPs

Includes: AIG, C, EPD, ETP, KMP, NS, TPP
by: Avi Morris

Last week (ending March 13), stock markets had an enormous rally. The Alerian MLP Index shot up from 168 at the beginning to close the week at 185. In addition, all high yield securities participated. The Dow Jones REIT Index jumped 20% while junk funds were up but with lesser gains.

MLPs have outpaced the Dow this year. The MLP index is up YTD, even if the year is handicapped by starting it after January 2 when MLPs had an unusually large advance. At the same time, Dow is down sharply. Going forward, MLPs will probably be affected by the strength (or lack of strength) in the stock markets, especially high yield sectors. My take is that, on balance, government massive spending will not be positive.

In April, MLPs will report earnings, set distributions and give guidance. I have a nervous feeling about what MLPs will have to say. They all have massive capital projects which are key to favorable taxes on distributions. So far their businesses (flows through the pipelines) have been strong. But even their businesses may feel a pinch from the weak economy. It's always difficult to properly assess results because they do not calculate or report distributable cash flows, however they report earnings. Distributable cash flow (per unit) is used to set the distribution rate.

Investors with long term time horizons will be attracted to MLPs because of the unusually high yields. The Alerian MLP Index yields 11.3%, a massive 840 basis point spread over the 10 year Treasury bond yield. Such a spread is unprecedented (other than when the index recently dipped below 185). In the past, the rule of thumb was that a 200 basis point yield spread was to be expected. A 3-400 point spread was thought of as a signal for buying. Not any more. All high yield securities have enormous spreads, rewards needed in this credit crisis.

MLPs will probably follow the lead of the markets, especially high yield stocks. These securities are watching government efforts to fix financial institutions. When Citigroup (NYSE:C) is selling for less than $2 a share (a price which could not be imagined a few months ago) and with the tremendous mess surrounding AIG, it is difficult to have encouraging thoughts about emerging from the credit crisis quickly.

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