Seeking Alpha

Distribution Coverage Analysis For MLP CEFs

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Includes: AMZA, CEM, CEN, CTR, DSE, EMO, FEI, FEN, FMO, FPL, GER, GMZ, JMF, JMLP, KMF, KYN, MIE, NML, SMM, SRV, TYG
by: Juan de la Hoz
Juan de la Hoz
Long only, ETF investing, dividend investing
Summary

MLPs and midstream corporations, currently some of the strongest yields available in the market.

MLP CEFs offer even stronger yields, as they can use cheap leverage to turbo-charge their assets, holdings, and distributions.

MLP funds are also infamous for offering unsustainable distributions. AMZA comes to mind.

To help investors choose MLP funds with strong, sustainable distributions, I've decided to calculate distribution coverage ratios for all MLP CEFs and AMZA.

Midstream energy companies and MLPs currently offer investors extremely attractive dividend and distribution yields. Double-digit yields are common, and some stocks even boast yields in the mid-teens, something that is relatively rare in most other industries. Leveraged funds are able to take advantage of this situation by taking on low-interest debt, investing in high-yield MLPs, and profiting from the spread. Done properly, this strategy will almost certainly boost long-term total shareholder returns and distribution yields, making investors very rich in the process.

Investing in a leveraged MLP fund seems like an easy way to receive outsized distributions and achieve market-beating returns, actually selecting an appropriate fund with sustainable distributions is much harder. Many funds engage in destructive NAV-eroding return of capital distribution, so distribution rates themselves are not very informative. Industry accounting standards also make it very difficult to properly gauge a fund's underlying income generation or distribution coverage ratio. Knowing which funds offer sustainable distributions is of critical importance in this industry, but this information isn't normally calculated, nor readily available.

In light of the above, and due to reader interest, I decided to calculate net income yields and distribution coverage ratios for all MLP CEFs and InfraCap MLP ETF (NYSEARCA:AMZA). These two metrics show how much actual income is generated by each fund, and how much of their distribution rate is covered by said income, respectively. I've included a table summarizing this information below, analyzed some of the information collected, and selected a fund with a particularly attractive distribution yield and coverage: ClearBridge Energy MLP Fund (NYSE:CEM).

I believe that this analysis will prove of use to investors and readers and will allow them to make better, more informed investment decisions.

Distribution Analysis for MLP Funds

I'll start with an overview of MLP distributions and some of my preferred metrics for MLP funds.

For most funds, calculating income figures and distribution coverage ratios is surprisingly easy. Income is equivalent to a specific accounting metric called investment income, which includes dividends, distributions, interest rate payments, and other assorted sources of income. Net income would be equal to investment income minus expenses, including management fees, interest expenses, and other assorted fees.

To facilitate comparisons between funds, the SEC requires all funds to calculate and post their SEC yields, which is basically equivalent to net investment income per share divided by price per share. SEC yields reflect the rate at which funds earn income and allow for easy and simple comparisons between funds. As a quick example, here is RQI's SEC yield:

(Source: RQI Factsheet)

Distribution coverage ratios would basically be equivalent to a fund's SEC yield divided by their distribution rate. RQI would have a distribution coverage ratio of (1.67%)/(6.06%) = 27.6%, quite low, as the fund's actual generation of income is much lower than its distributions to shareholders.

For MLP funds, the situation is a bit more difficult, as MLPs have complicated, sometimes, outright byzantine, accounting standards. Investment income explicitly excludes any return of capital distributions from the fund's holdings. As most MLP distributions are return of capital, investment income excludes the vast majority MLP distributions from its calculations. This technically means that most MLP funds generate very little in income.

As an example, KYN, the largest MLP CEF, generated $63 million in dividends and distributions in the last quarter, but only $13 million in investment income. The vast majority of the fund's dividends and distributions aren't technically included in the fund's investment income metric, or in any other relevant income metric:

(Source: KYN Semi-Annual Report 2019)

Look through the financial statements of basically any MLP fund and you'll find more or less the same. Most MLP funds technically generally very little in income, and in many cases, expenses are significantly greater than income generated. This is, of course, mostly an accounting fiction. MLP funds generate quite a bit of income from MLP distributions, even if most GAAP metrics say otherwise.

In light of the above, many analysts and fund managers have devised new non-GAAP income metrics that are more appropriate and informative for MLP funds. Net distributable income, or NDI, is one such metric. NDI is basically equivalent to a fund's dividends plus distributions, including MLP distributions, minus expenses. This metric more accurately reflects the actual income generated by an MLP fund, is roughly analogous to more commonly used metrics, and is relatively easy to calculate to boot. As an example, here is KYN's NDI:

(Source: KYN Semi-Annual Report 2019)

You can also easily use those NDI figures to calculate a fund's distribution coverage ratio, defined as NDI per share/distributions per share. For KYN, their distribution coverage ratio would be equivalent to ($0.341)/($0.360) = 94.7%, meaning the fund is able to cover about 95% of its distributions to shareholders with dividends and distributions from its underlying holdings. The remaining 5% is covered through asset sales.

You can also easily use these NDI figures to calculate an NDI yield, defined as NDI per share/price per share, roughly analogous to the more well-known SEC yields. For KYN, their NDI Yield would be roughly equivalent to ($0.341 * 4)/($13.49) = 10%, meaning the fund generates 10% in income for its shareholders every year. In many cases, I thought it was easier to calculate this by multiplying a fund's distribution rate times its distribution coverage ratio. In KYN's case, this would basically be (10.58%) * (94.7%) = 10%. In any case, a fund's NDI yield basically tells us how much income is generated by the fund, net of fees.

Some readers and analysts prefer to use gross income figures, disregarding expenses, but I believe that the net figures are more reflective of the actual income generated by these funds, more consistent with commonly used accounting standards, more commonly used by fund managers, and simply much more informative for prospective investors.

Let's summarize all of the above.

Income is usually calculated using two metrics: investment income and SEC yields. These two figures explicitly exclude most MLP distributions and, as such, are not appropriate for analyzing MLP funds. Net distributable income includes MLP distributions and, as such, is an appropriate figure/metric for MLP funds. I've calculated yields and distribution coverage ratios for these same funds using NDI figures, as I believe that these two metrics will prove of use to investors and readers.

Distribution Analysis Results

Without further ado, a table summarizing the yields and distribution coverage ratios for applicable MLP funds. Funds are ordered by coverage ratio:

(Source: Cefconnect.com - Chart and calculations by author)

Tons of interesting choices out there, but I believe that the clear winner of this little exercise is little-known CEM. This fund boasts an 11.50% distribution rate, 98.9% distribution coverage ratio, trades at a nice 12.30% discount to NAV, and has achieved market-beating total shareholder returns since inception:

ChartData by YCharts

Some other assorted comments:

  • Both GS MLP Income Opportunities Fund (NYSE:GMZ) and Goldman Sachs MLP and Energy Renaissance Fund (NYSE:GER) offer extremely attractive, fully-covered distributions, but the funds have performed disastrously since inception. CEM seems like a better choice.
  • Center Coast MLP & Infrastructure Fund (NYSE:CEN), AMZA, and Cushing MLP & Infrastructure Total Return Fund (NYSE:SRV) have relatively low distribution coverage ratios and are at significant risk of a distribution cut.
  • CEN's and SRV's distributions are unsustainable in the long term, but they can probably be maintained for a year or two.
  • AMZA's distribution seems much more likely to be cut in the near future. Taking into consideration the fund's current coverage ratio, a cut of +40% seems likely. Trapping Value comes to a very similar conclusion here.
  • In a previous article, I estimated CEN's yield as 8%, while the correct figure seems to be 9.5%. In that previous article, I used Seeking Alpha's expense ratio of 3.7% to calculate these figures, but it seems that the fund's actual expense ratio is closer to 2.6%. Sorry for the issue, and thanks to the readers who pointed this out.
  • First Trust Energy Income & Growth Fund (NYSEMKT:FEN), my top MLP fund, carries an uncharacteristically low distribution coverage ratio as the fund is/was holding quite a bit of cash.
  • NDI yields and distribution coverage ratios are calculated using relatively old data, while distribution rates are calculated using more recent information, so analyzing the three figures at the same time might yield odd results.
  • Distribution rates were taken from CEF Connect which seems to have slightly higher rates than Seeking Alpha.
  • Figures for FEN, First Trust MLP and Energy Income Fund (NYSE:FEI) and First Trust New Opportunities MLP & Energy Fund (NYSE:FPL) were very difficult to find and calculate, so different analysts or readers might calculate things a bit differently.

Conclusion

Investors should consider a fund's yield and distribution coverage ratio before making any final investment decision and should probably avoid funds with unsustainable distributions and suckers yields. As such, I believe that the information provided in this article will help investors make better, more informed decisions.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.