Using Closed-End Funds vs. Master-Limited Partnerships

Includes: AMJ, TYG
by: Lee Eugene Munson, CFA

Co-written by Lorn Davis

When most people talk about master-limited partnerships (MLPs) they concentrate on the tax issue. We at Portfolio Asset Management look at MLPs more as cash flow producers that are uncorrelated with the stock and bond markets. In our opinion the tax issue is, more than anything, plain and simple tax confusion. The tax benefits an investor might get from investing in an MLP will not be realized until they receive their K-1s. So investors should be more interested in the distributions of these MLPs than the tax breaks because that’s where they will really earn money.

Furthermore, a direct purchase of MLPs in an IRA is a questionable tactic because MLP distributions are classified as ordinary income and would be subject to tax as it is considered to be unrelated business taxable income. Now, however, there are closed-end funds that have devised structures to take advantage of the distributions of MLPs and avoid the hassles of multiple K-1s and multiple state filings for the shareholders.

Investing in a closed-end fund such as Tortoise Energy Infrastructure Corp. (NYSE:TYG) that focuses on producing distributions close to what an investor would get if they were directly invested in the MLPs, presents an attractive opportunity that is uncorrelated with the market and also dispels the tax confusion surrounding MLPs. TYG invests in MLPs in the energy infrastructure sector meaning they are involved in the processing, storing and transporting of crude oil, natural gas, and other similar energy commodities.

More specifically TYG prefers to invest in midstream (pipeline) operations, which produce steady cash flow because they are not exposed to fluctuations in the commodity pricing or involved in searching for new sources. Midstream MLPs generate income on the volume of processed, stored or transported materials creating growth in line with the economy and increased demand.

This of course means the MLPs that TYG invests in were hard hit last year, not just from the economic downturn but also from the pullback of hedge funds as they deleveraged. This caused the market capitalization of the partnerships to drop 28% from 2008 to 2009, though 87% of MLPs maintained or raised their distributions in a strong showing of dedication to cash flow production instead of reinvesting them internally as they have the ability to do, unlike REITs.

Though this did not translate to higher distributions from TYG this year as the amount dropped two pennies, remaining instead at the same level of $0.54 for the past two quarters, the NAV and stock price of TYG climbed steadily since the beginning of the year giving a current yield of 8.1%.

This has one positive aspect: the NAV is close to the inception NAV, the sign of a good manager. We don’t want to see double-digit distributions and a declining NAV, for that would indicate that the managers are just burning through the assets and passing on the profits as distributions, obviously an unsustainable and false cash flow producing practice.

Despite that particular positive feature there is something more problematic with TYG, namely the fact that the share price premium over NAV has also been increasing since the beginning of the year and could be an indication that investors expect the fund to perform well enough to justify paying almost 20% over the value of the assets held. But looking at the historical share premiums since inception, the average was around 10% and this ramping up in the share premiums is worrisome to us at Portfolio Asset Management.

This historically high premium is especially important given the recent launching of JP Morgan’s Alerian MLP Index Exchange Traded Notes (ticker: AMJ) which tracks the midstream MLP index and pays a variable quarterly coupon based on the distributions of the MLPs and AMJ, which like TYG, bypasses the cumbersome K-1s, reporting its coupons as ordinary income. The real draw of AMJ is that it is openly traded and its price tracks the index daily, as opposed to the delayed pricing for closed end funds like TYG, which causes the premium/discount phenomenon.

AMJ’s first coupon payment paid $0.45 per note which becomes more exciting when taking into consideration that the tracking fee paid is 0.85% a year versus the management fee of 1.14% for TYG. However AMJ is not perfect and exposes investors to the credit risk of JP Morgan because it is unsecured debt of the company, but currently the company appears to be in a solid position.
So although fundamentally we like TYG, we are concerned with the premiums getting out of hand. When choosing between TYG or investing in a product similar to AMJ, AMJ simply wins out in terms of the benefits over drawbacks.

Remember that our primary concern when seeking to gain exposure to the midstream MLP industry is cash flow, so if the ability to generate cash flow without the tax confusion or jacked up share premiums is the same, the choice becomes clear for us when deciding where to invest our client’s money. We would consider flipping the two when TYG’s share price is discounted or level with its NAV.

Disclosure: Long AMJ at time of writting.