MLPs Keep Roaring Ahead

by: Avi Morris

MLPs keep roaring ahead, taking them to new yearly highs. It seems like we're in a new world when remembering last October. I had just written a primer article on MLPs, introducing many investors to a new type of investment. That was at the start of September, after MLPs had already fallen 20% from their peaks in the prior year (along with other market averages). Then they plunged and by October it looked liked they were heading for zero. Risk averse was the driving force in investment thinking, all securities with high yields were being thrown away without regard to their investment value. The collapse of Lehman (OTC:LEHMQ) in September made matters worse for MLPs because they had been a big believer (and investor) in MLPs. MLPs went through an awful 6 months as yields shot up to over 15%. But believers were rewarded.

From their lows, MLPs have rebounded sharply. The Alerian MLP Index (AMZ) at 265, is up a dazzling 100+ points from the lows in March. Aside from a modest setback in June and settling into a trading range during August-September, the rise has been about as steady as could be hoped for. In October, the index is up 10% from the low of the latest trading range.

The reasons for this optimism are simple. MLPs have gotten through the credit crisis in excellent shape. They continued to sell units to boost equity, allowing more borrowings to finance expansion of pipelines and terminals (long term assets). Kinder Morgan (NYSE:KMP) is the largest MLP. They've raised over $750 million in 2009 (75% of their goal for 2009) by selling units which allowed them to increase borrowings. Last month Enterprise Products Partners (NYSE:EPD) sold $250 million in units and arranged to borrow an additional $1.1 billion. In addition, a merger with TEPPCO Partners (TPP) was just approved by TEPPCO unit holders at a special meeting. This will create the country's largest MLP with a value of approximately $30 billion. Other MLPs are buying additional assets (terminals, etc.), those transactions are part of their large capital expansion programs. These stories are common among MLPs, they have been able to finance expansion during the credit crisis.

OK, it has not all been smooth. A couple of smaller MLPs, such as Constellation Energy (CEP) and Breitburn Energy Partners (BBEP), have had to eliminate distributions so they could concentrate on reducing debt. But they are making progress and their units have more than doubled from the 2009 lows. Quarterly updates will be released next week.

For those new to MLPs, a little extra explanation may be helpful. Investors buy units (not shares) in master limited partnerships (MLP). MLPs pay distributions which are typically 80-90% tax free and their yields are high. But tax free brings tax hassle. A yearly K-1 tax statement is sent around early March with terms like depletion and amortization that have to be dealt with. However I've been told that tax preparation programs help with tax preparation. In addition, records have to be kept since the cost basis of the investment is reduced.

Risk premium, the spread of the yield on the Alerian MLP index over the yield on the 10-year Treasury bond, is very important. The rule of thumb had been that a 200 basis point spread was to be expected. A narrowed spread indicated a good time to sell. MLPs peaked in July 2007 with a spread near zero when the yield on the Treasury bond had risen to 5¼%. That was the time to sell. A few months ago the premium shot up to well over 1000 basis points, signaling a good time to buy MLPs at low prices. The yield on the Alerian MLP Index is currently 7.8%, down sharply from 15% earlier this year, with a spread of more than 400 basis points. Bulls would say this spread still gives a buy signal (based on the 200 point basis point standard). Bears would say the risk is higher now, justifying a larger spread.

There are ways to invest in MLPs by buying stock. A new tracking ETF (NYSEARCA:AMJ) is priced at 10% of the Alerian MLP Index value. It rises and falls along with the Alerian Index and provides a dividend from net distribution income. 2 of the largest MLPs have stock equivalents in addition to their units:

Kinder Morgan (NYSE:KMR)
Enbridge Energy (NYSE:EEQ)

These are called management corporations, each share has one unit backing it and generally sells at a small discount to the unit value. When distributions are paid, shareholders receive an equivalent stock dividend. Being corporations, they are retirement account friendly and tax efficient for individual accounts since there is no need to issue a 1099 tax form. The stock dividends make for a very efficient automatic dividend reinvestment program.

The astounding rise this year comes from greater recognition that MLPs have gotten through the credit crisis without significant problems. They have high yields which are largely tax-free, units have low beta price movements and their track record of growth is excellent at a time when shaggy long term track records are common. The Alerian Index has grown 2.7 times in 15 years. With reinvested income included, that index has grown 6.9 times. MLPs are overbought short term, but a pullback by MLPs should provide a better time to invest for term growth and income.

Disclosure: no positions