As the Federal Reserve continues along its path of raising interest rates, many MLP investors have asked how these actions will impact MLPs. We believe there are two key considerations when assessing this question:
- At the entity-level, how will rising rates affect the ability of MLPs to cheaply borrow money to fund capital expenditures (capex)?
- At the investor level, how does higher rates impact investor demand for MLPs?
In this piece we will focus on addressing question 1 by analyzing the nature of the debt issued by midstream MLPs.
Given that MLPs distribute a significant portion of their cash flows to their unitholders, MLPs have historically been dependent on funding growth by raising capital either through equity or debt issuances. Recently, this has been changing, with a number of MLPs seeking to move to a self-funding model by retaining more cash flow to pay down debt and fund future growth opportunities. Given the recency of this shift, however, many MLPs still have leverage ratios (debt-to-EBITDA—Earnings before Interest, Taxes, Depreciation, & Amortization) between 4x and 5x, meaning debt continues to be an important part of their capital structure.
According to our research, 78% of midstream MLP debt is fixed-rate in nature, meaning coupon payments will remain the same throughout the life of the bond regardless of the rate environment. Of the remaining debt in the MLP space, 17% is floating rate that is expected to experience increasing service costs as rates rise. The remaining 5% is structured as variable rate debt, usually in the form of fixed-to-float, where the bond pays a fixed rate for a specific period and then converts to a floating rate in the future.
At the entity level, the fact that over 3/4s of MLP debt is fixed helps insulate those MLPs from rising rates because the cost of servicing existing debt will not change even as rates rise. It is important to note however that debt that reaches maturity and is rolled over may need to be issued at a higher rate. In addition, new debt offerings, such as those to finance future capex projects, could require higher rates than existing debt.
Source: Global X using Bloomberg data. Midstream MLPs represented by the Solactive MLP & Energy Infrastructure Index, which includes MLPs, Energy Infrastructure Corporations, & General Partners of MLPs. Data as of 4/4/18.
For comparison’s sake, midstream MLPs have a relatively low amount of floating rate debt compared to various sectors. In the chart below, we show that more cyclical sectors like Consumer Discretionary and Financials currently have higher amounts of floating rate debt. Energy and Utilities, which have some similar properties as MLPs, tend to have the lowest percentages of floating rate debt.
Source: Bloomberg. Data as of 4/23/18. Debt universe classified as active US corporate bonds and corporate loans that have a floating rate, fixed rate, and variable rate/step-up coupons.
As rates move higher, investors may want to begin evaluating which sectors could have the most sensitivity to rising rates. We believe that cash flows for the midstream MLP sector should be well insulated from rising rates given that the majority of their debt is fixed-rate. As rates move higher, we believe it makes an even stronger case for MLPs to self-fund growth in an effort to avoid seeing increased costs of capital in the debt markets.
Variable rate debt: variable rate debt is where the coupon may change during the life of the bond, possibly in the form of a fixed rate coupon to a floating rate coupon or two different fixed rate coupons. The date when this change occurs is pre-defined.
Floating rate debt: floating rate debt is where the coupon is usually referenced against an interest rate benchmark such as LIBOR (London Interbank Offering Rate) and includes an additional pre-defined interest spread on top of that reference rate.
The Global X MLP Funds do not invest in the debt of MLPs, but rather the MLPs themselves.
Global X Management Company, LLC serves as an advisor to the Global X Funds. The Funds are distributed by SEI Investments Distribution Co., which is not affiliated with Global X Management Company, LLC.
Investing involves risk, including possible loss of principal. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Investments in securities of MLPs involve risk that differ from investments in common stock including risks related to limited control and limited rights to vote on matters affecting the MLP. MLP common units and other equity securities can be affected by macro-economic and other factors affecting the stock market in general, expectations of interest rates, investor sentiment towards MLPs or the energy sector, changes in a particular issuer’s financial condition, or unfavorable or unanticipated poor performance of a particular issuer (in the case of MLPs, generally measured in terms of distributable cash flow). The Global X MLP Funds invest in the energy industry, which entails significant risk and volatility. The Funds invest in small and mid-capitalization companies, which pose greater risks than large companies. The Funds are non-diversified.
The potential tax benefits from investing in MLPs depend on them being treated as partnerships for federal income tax purposes. If the MLP is deemed to be a corporation then its income would be subject to federal taxation at the entity level, reducing the amount of cash available for distribution to the fund which could result in a reduction of the fund’s value.
MLPA has a different and more complex tax structure than traditional ETFs and investors should consider carefully the significant tax implications of an investment in the Fund. MLPA is taxed as a regular corporation for federal income tax purposes, which differs from most investment companies. Due to its investment in MLPs, the fund will be obligated to pay applicable federal and state corporate income taxes on its taxable income, as opposed to most other investment companies. The fund expects that a portion of the distributions it receives from MLPs may be treated as tax-deferred return of capital. The amount of taxes currently paid by the fund will vary depending on the amount of income and gains derived from MLP interests and such taxes will reduce an investor’s return. The fund will accrue deferred income taxes for any future tax liability associated certain MLP interests. Upon the sale of an MLP security, the fund may be liable for previously deferred taxes which may increase expenses and lower the fund’s NAV.
Shares of ETFs are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Brokerage commissions will reduce returns.
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