High Income Investments Reduce Exposure To Europe, Increase Returns: Part II

Includes: KMI, KMP, KMR
by: The Wall Street Transcript

In Part 1 of “High Income Investments Reduce Exposure To Europe, Increase Returns,” U.S. publicly traded REITs specializing in college campus housing were seen as lower risk while providing investors with both current income and future growth. This sub-sector also isolates portfolio returns from international economic and currency risks. Part 2 will explore Oil and Gas MLPs as another asset class that can mitigate risk while increasing returns. Part 3 explores high rated Oil and Gas MLPs and has specific MLP recommendations.

Master Limited Partnerships (MLPs) are publicly traded and liquid investment vehicles created to encourage US investment in domestic infrastructure.

James J. Cunnane Jr., Chief Investment Officer of Fiduciary Asset Management (FAMCO) put it this way in a recent interview:

It probably makes sense to step back and look at infrastructure, and even infrastructure is a term that is defined differently by many investors out there. Infrastructure can be defined as broadly as roads and hospitals and water facilities, in addition to the large amount of energy infrastructure that's in the US marketplace. MLPs are defined by the tax code; you have to qualify under the tax code to be an MLP.

A good analogy for MLPs are real estate investment trusts, or REITs, which similarly have to qualify to be a REIT under the tax code. To be an MLP, you have to have assets that are qualifying assets under the tax code, and so the question is what are the qualifying assets? Many of the qualifying assets tend to end up in the energy infrastructure business. And so right now, a large majority of MLPs are composed of assets that are energy infrastructure assets.

What's really critical though is not so much how you qualify to be an MLP, but why do MLPs exist? MLPs exist because MLPs have the benefit of being a partnership, meaning that there is no corporate-level taxation, so it's a very tax-efficient structure. Additionally, they are publicly traded, so they are able to get the liquidity that's typically only afforded to corporations. To some extent, you get the best of those worlds - the tax treatment of a partnership and the liquidity of a corporation. Generally assets that qualify to be MLPs, people want to put in the MLP format to take advantage of these benefits.

What's happened over time is that a large majority of the pure-play US energy infrastructure assets that do publicly trade are in the MLP format. If you want access to pure US infrastructure, generally the way you get it as an investor is through MLPs.

Then the question becomes why do investors buy MLPs? What is it besides the access to infrastructure that they like?

The answer to that is that there are really four features of MLPs that investors really like.

One is the high level of current income.

The second feature that investors like is the growth potential that MLPs have. It's important to note that MLPs are real operating companies, which can make acquisitions and grow organically. The combination of that current income, the distribution yield plus that growth potential creates opportunity for double-digit type returns.

The third thing that investors find attractive about MLPs is that they've historically had fairly low correlations against the U.S. stock market, against the U.S. bond market and even against commodities such as crude oil.

The fourth thing, and this is relevant to taxable investors, is that MLPs have a very favorable tax treatment for investors. Almost all MLP taxation is paid upon sale of the asset, so a lot of the current distribution is tax deferred and capital gains are also deferred until sale. For taxable investors, particularly those with longer time horizons who are willing to manage with low turnover, there tends to be a lot of tax advantages.

That combination of high-yield, growth potential, low correlations and tax features are really a potent combination that investors have found very attractive.

In the United States, energy from various North American sources -- such as coal, oil and natural gas -- is distributed through a well-developed energy system to electrical power plants. Coal accounts for almost 50% of all electricity produced domestically and is distributed through the rail system; oil and natural gas are distributed to petrochemical-processing facilities that create both raw material for industry and process the fuel for use in energy generation plants. MLPs have become the investment vehicle of choice to source, process and distribute natural gas.

Natural gas generates almost 25% of the electricity in the United States, and heats about 50% of the homes, according to information from the U.S. Department of Energy. And gas consumption is growing. New sources of natural gas were discovered in shale beds throughout the country, bringing the price down and creating significant new upside demand for storage and distribution systems.

Kimberly Allen Dang is the Chief Financial Officer of Kinder Morgan, one of the largest pipeline transportation and energy storage companies in North America. The Kinder Morgan companies include Kinder Morgan Energy Partners, L.P. (NYSE:KMP), Kinder Morgan Management LLC (NYSE:KMR) and Kinder Morgan, Inc. (NYSE:KMI).

She explains in a recent interview with The Wall Street Transcript how the MLPs are organized:

KMP is a master limited partnership that owns and operates assets that are core to the energy infrastructure of North America. We are a fee-for-service business, similar to toll roads, where our customers pay us a fee to either transport or store their products via our pipelines or terminals...There are two important characteristics of MLPs. First, they pay out virtually all of their cash flow to their investors. And second, they're not subject to U.S. corporate income tax. So they're a very efficient place to own qualifying assets.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.