This post is an excerpt from a blog published recently: Paired Trade Roth IRA: Sold 50 KKR at $23.25 and Bought 50 AMJ at $45.95
The exchange traded notes that track infrastructure energy MLPs have declined in value over the past several weeks in sympathy with the substantial decline in crude prices.
Crude Oil Prices: West Texas Intermediate (WTI)-Cushing, Oklahoma-St. Louis Fed
Other than MLP Exploration and Production companies, most of the infrastructure MLPs have limited direct exposure to commodity prices, as noted in the discussion below.
Due to the price declines in MLP infrastructure companies over the past several weeks, I decided to buy the JPMorgan Alerian MLP Index ETN AMJ in the Roth IRA. I have also recently discussed here adding 50 shares of the MLP ETN MLPG: Bought Back 50 UBS AG E-TRACS Linked To Alerian Natural Gas MLP Index At $36 - UBS ETRACS Alerian Natural Gas MLP Index ETN [MLPG] | Seeking Alpha
Bought Back 50 AMJ at $45.95 Roth IRA (see Disclaimer):
Snapshot of Trade:
The closing "indicative value" on 12/26/14 was $46.02.
Security Description: The J P Morgan Alerian MLP ETN as indicated by its name, an exchange traded note (ETN) that tracks the Alerian MLP Index.
The Alerian MLP Index consists of MLPs involved in various aspects of the energy business, including pipelines, production, storage, gathering and processing. This index has a light exposure to a few beaten up E&P MLPs, including Linn Energy (NASDAQ:LINE); Memorial Production Partners LP (NASDAQ:MEMP), and Vanguard Natural Resources (NASDAQ:VNR)
I generally keep my exposure to ETNs limited, since that form of ownership exposes me to the issuer's credit risk, in addition to the numerous risks associated with the index being tracked by the ETN as well as other risks relating to this product. "Exchange-Traded Notes Avoid Unpleasant Surprises- FINRA; NYSE Publication: "What You Should Know about Exchange Traded Notes.pdf.
ETNs are unsecured senior notes. I am reasonably comfortable with the JPM credit risk, so I will buy 50 shares and will occasionally harvest profits as noted below.
I would simply explain the credit risk as follows. If JPM went bankrupt, the owners of AMJ are screwed. The investors who owned Lehman unsecured senior notes found out the hard way about the value of those notes in a bankruptcy.
Sponsor's Website: JPMorgan Alerian MLP Index ETN
The sponsor, J P Morgan, quit creating shares in this ETN back in 2012, and consequently this ETN has taken on some of the characteristics of a closed end fund.
The AMJ senior unsecured note matures on 5/24/24. The ETN structure has a complicated issue relating to the sponsor's redemption of the note. The calculation is difficult to comprehend and is explained starting at page PS-8 of the Prospectus. To deal with this kind of issue, I will simply avoid owning this security on or 1/1/2020.
I believe that this is the quote for the Alerian MLP VWAP Level Index which appears to be used in that calculation. The Initial VWAP Level is shown as 190.36605. Amendment No. 11 to Pricing Supplement No. 152 I also read that the principal amount of the note is Initial VWAP Level dividend by 10 or just over $19.
This ETN does not own any of the securities that are components of the index.
The sponsor's website did not have an updated list of the index's components, and still had KMP as a member of the Alerian MLP Index. The sponsor's website was deficient in other respects as well, including no reference to the recent distribution payment in the distribution history as well as omitting some other prior historical dividends. I give JPM an "F" for its poor AMJ website.
Kinder Energy Partners, which formerly traded under the symbol KMP, did have close to a 10% weighting in that index when I last bought some AMJ shares. KMP is no longer a component after being acquired by Kinder Morgan, Inc. (NYSE:KMI).
I consequently went to the Alerian website and downloaded the current components and their weightings as of 12/19/2014.
Constituent Members as of 12/19/14:
Quotes for Top Five Holdings with 12/26/14 Closing Prices (weightings as of 12/19/14):
Total Weighting TOP FIVE= 46.37%
With both MLP ETN and ETFs, I can avoid the K-1 hassle.
Since I prepare my own tax returns, I am going to avoid the tax preparation issues connected with owning MLPs directly, which involves imputing K-1 data into my tax return. I have been there and done that. When and if I ever decide to hire a CPA, I will start owning them directly again.
Total Realized Trading Gains: $569.39
AMJ Distributions: The distributions are paid quarterly at a variable rate that is linked to the distributions paid by the MLPs in the index less accrued tracking fees. The tracking fee is high at .85%.
The dividends will be taxed at ordinary income rates so I bought this last lot in the Roth IRA where I effectively turn the distributions into tax free income.
The last distribution for 2014 went ex dividend on 11/26/14. JPMorgan Chase & Co. Declares Quarterly Coupon on Alerian MLP Index ETN
In 2014, this security paid $2.3278 per share in distributions. AMJ Dividend Date & History The total distribution for 2013 was $2.1887.
The Y-O-Y distribution increase was 6.355%.
If I assumed a 6.3% increase in 2015 over the $2.3278 rate for 2014, the total distribution would be about $2.474. Assuming further a total cost per share of $45.95, the dividend yield would then be about 5.38%.
Rationale: Given the dividend yield, I can achieve a 10+% total return with about a 4.6% in rise in the share price after commission next year, assuming a 6.3% distribution increase, and less with distribution increases in the out years.
Many of the infrastructure MLPs have a history of steadily rising distributions.
I will just link the dividend history webpages for the 5 largest weightings:
(1) Income May be Devoured by a Loss on the Shares: MLPs have been volatile recently with a downside bias. The downside pressure has coincided with the precipitous decline in crude oil prices.
AMJ closed at $53.83 on 9/19/14, declined to a $45.72 closing price on 10/14, shot back up to $52.4 on 11/20 and then hit another air pocket with a spike down to $42.11 (12/15) before recovering some to the date of my purchase. Peak to valley over about a 3 month period was about a 21.77% variance.
My purchase price of $45.95 represented a 14.64% decline from the 9/19/14 closing price.
AMJ's volatility in price indicates to me that investors have become more uncomfortable with MLPs, most likely due to the unsettling decline in crude oil prices.
It does not take much of a price correction to wipe out a 5% yield. Hopefully, the recent volatility will simmer down, as investors realize that most of these MLPs are not directly exposed to energy prices and will consequently focus more on the long term benefits associated with the infrastructure MLPs including rising payouts.
Part of the distribution has been offset by price depreciation YTD through 12/26/14. Morningstar calculates the YTD total return number at +3.25. The annualized total return over 5 years through 12/26/14 was 15.34%.
(2) JPM Default Risk: I would just note that this risk does exist, even though it is remote based on what we know now.
(3) Risks Associated with the Securities in the Alerian MLP Index: There are risks associated with the securities tracked by the index that are discussed in the prospectus. There may be added risks coming from Congress in future years due to changes in the tax code as the government attempts to raise more money.
(4) Sponsor's Discussion of Risks: The sponsor discusses risks relating to AMJ in the Prospectus starting at page PS-17. A summary of risks can be found in the pricing supplement which can be downloaded at the sponsor's website: JPMorgan Alerian MLP Index ETN
(5) Increasing Correlation with Crude Oil: Over the past ten years, energy infrastructure MLPs have had a .38 correlation with crude oil prices, as noted by the Oppenheimer Funds' Director of Research. Since 2010, however, there have been 5 periods when WTI crude declined more than 15%, with an average 22% decline, and the Alerian MLP index has declined by more than 11% on each such occasion.
Some MLPs in that index have more exposure to crude oil and natural gas prices including the E & P MLPs and those with commodity exposed gathering and processing. Cohen and Steers MLP Strategy November 2014 Other companies, including the pipelines, have more of a fee based cash flows under long term contracts.
Another firm, CBRE Clarion, argues that the majority of MLPs have fee based businesses "that are not directly exposed to the price of any commodity". MLPs that operate in the oil infrastructure business "tend to operate under fee-based contracts that have volume risk, not commodity risk". "MLP Prices Driven by Secular Demand for Energy not Oil Prices" JP Morgan has also noted that most "core energy infrastructure MLPs possess limited direct commodity price exposure; these business models are akin to toll roads as volumes times tariffs largely drives profitability". Barrons.com
While CBRE and JPM are expressing my understanding of the commodity exposure outside of the E & P MLP sector, the market has increasingly sold off MLP infrastructure companies during crude oil declines. If this proves to be a irrational correlation based on future MLP earnings reports, then the market will hopefully revisit the wisdom of the MLP infrastructure selloff.
(6) Note Valuation at Maturity: As I mentioned above, the maturity value of this note will be difficult for most individual investors to calculate. Trying to understand the calculation caused my head to hurt so I just quit trying to figure it out.
(8) Non-Temporary Rise in Interest Rates: A rise in interest rates will increase borrowing costs for MLPs and increase the competitiveness of other income investments that lack the tax preparation issues involved with direct ownership.
Last year, the ten year treasury rose from a 1.66% yield (5/1) to 3.04% (12/31/13). Daily Treasury Yield Curve Rates Unadjusted for distribution payments during that same period, AMJ held up well in that period, closing at $46.35 on 12/31/13, up slightly from a closing price of $45.98 on 5/1/13.
A more permanent rise to normal historical levels for the ten year treasury and other income generating securities competing for investors' dollars may have a significant adverse impact on MLP unit prices.
I can only speak for myself on the yield competition issue. I would have significantly less exposure to risk categories with a ten year treasury at 4% or higher. The rise in rates last year was from an extremely low level to a less abnormally low level.
Younger investors have not actually had to cope with a problematic inflation scenario, such as the that started in the mid-1960s: Consumer Price Index, 1913- | Federal Reserve Bank of Minneapolis
Disclosure: The author is long AMJ, MLPG.
Disclaimer: I am not a financial advisor but simply an individual investor who has been managing my own money since I was a teenager. In this post, I am acting solely as a financial journalist focusing on my own investments. The information contained in this post is not intended to be a complete description or summary of all available data relevant to making an investment decision. Instead, I am merely expressing some of the reasons underlying the purchase or sell of securities. Nothing in this post is intended to constitute investment or legal advice or a recommendation to buy or to sell. All investors need to perform their own due diligence before making any financial decision which requires at a minimum reading original source material available at the SEC and elsewhere. Each investor needs to assess a potential investment taking into account their personal risk tolerances, goals and situational risks. I can only make that kind of assessment for myself and family members.