CTR: A High-Risk, High-Reward Way To Play Midstream Strength

Summary

• ClearBridge MLP and Midstream Total Return Fund is a closed-end fund that invests in energy sector infrastructure companies, including master limited partnerships.
• The fund manages tax issues on the fund level, making it suitable for inclusion in tax-advantaged accounts.
• The fund has a yield of 8.73% and has outperformed the Alerian MLP Index over the past three years.
• The fund has significantly underperformed the index during periods of industry weakness, suggesting that it is a high-risk, high-potential return play.
• The distribution and valuation are quite reasonable, so the fund might make sense for someone who is comfortable with the risks.
• This idea was discussed in more depth with members of my private investing community, Energy Profits in Dividends. Learn More »

onurdongel

ClearBridge MLP and Midstream Total Return Fund Inc. (NYSE:CTR) is a closed-end fund that invests in infrastructure companies that serve the energy sector. As the name of the fund suggests, several of these companies are structured as master limited partnerships, which can pose some problems for investors that are seeking to include them in a retirement account or other tax-advantaged account. This is because of tax laws that can cause the presence of these companies to expose your retirement assets to current income tax liability. This fund manages to overcome that problem as it handles all tax issues on the fund level, allowing any investor to include it in a tax-advantaged account just as they would any other corporation. The fund also offers a number of other advantages to investors, such as the ability to easily purchase a diversified portfolio of midstream companies without having to sacrifice their income potential or having access to a substantial amount of capital. As of the time of writing, the ClearBridge MLP and Midstream Total Return Fund has a yield of 8.73%, which is very much in line with the Alerian MLP Index (AMLP).

As regular readers may recall, we last discussed this fund back in July. At that time, the fund only had a 7.06% yield and was trading at a massive discount on the net asset value. It has increased its distribution since that time and the market has rewarded it appropriately. In fact, this fund’s shares are up 5.04% over the past three months:

Seeking Alpha

This gain is not necessarily due to the increased distribution, however. Crude oil prices have begun to trend up and this has benefited most things connected to the fossil fuel energy sector, such as this fund. In addition, master limited partnerships and midstream companies are short-duration assets and as I discussed in a recent article, short-duration assets can do quite well in a rising interest rate environment. This is particularly true when the yield of the asset is above that of the risk-free rate, as most midstream companies are (other short-duration assets like utilities are not always quite so lucky).

As almost three months have passed since we last discussed the ClearBridge MLP and Midstream Total Return Fund, it is worthwhile to revisit it and see what things may have changed with the fund and in the broader economy that could affect our thesis. One very notable thing that has occurred is that the fund released its semi-annual report, so we certainly want to have a look at its finances and determine how sustainable the new higher distribution is likely to be.

About The Fund

According to the fund’s website, the ClearBridge MLP and Midstream Total Return Fund has the objective of providing its investors with a high level of total return. This is not at all surprising considering that the fund primarily invests in common equities issued by midstream partnerships and corporations. As we can clearly see here, 97.21% of the fund’s assets are invested in common equity with the remainder in cash:

CEF Connect

A few days ago, I discussed how this makes a great deal of sense for a midstream infrastructure fund. While midstream companies issue securities other than common equity such as preferred stock and bonds, it makes no real sense for any fund pursuing total returns to invest in these securities. From our earlier discussion:

The high yield on the common equity in many cases gives master limited partnerships a higher yield on the common equity than on the preferred. In such an environment, it makes no real sense for a fund seeking total return to purchase the preferred equity over the common equity. After all, the common equity has a higher yield and significantly better capital gains potential so it will almost always be the higher returning investment. The only real reason to purchase the preferred is that the preferred equity will be less volatile than the common equity. This could be advantageous during certain circumstances but generally, the common equity of midstream companies is reasonably low volatility. In addition, the preferred equity is theoretically safer in a bankruptcy or forced liquidation scenario. However, in most bankruptcy situations, the assets of the company are insufficient to cover all of the debt so both the common unitholders and the preferred investors will get wiped out. Additionally, I doubt very much that most people who want to buy a midstream fund are expecting to invest in companies that are threatened with bankruptcy! Thus, there is no real reason for a fund like this to purchase anything except for the common equity of midstream companies.

With that said the fund’s description of its strategy does not appear to preclude investing in preferred equity or even bonds issued by midstream corporations and partnerships. Here is what the fund’s website actually states about its objectives and strategies:

Franklin Templeton

The fund is explicitly stating that it is targeting midstream master limited partnerships and corporations, but that is all. This statement could thus conceivably mean that the fund might invest in any securities issued by a company falling into this category. However, apart from very rare situations like the crude oil bear market of 2015 or the COVID-19 lockdowns that cause capital to flee from the energy sector and potentially force midstream companies to slash their dividends and distributions, there is no real reason to purchase anything except for the common equity.

As regular readers are no doubt well aware, I have devoted a considerable amount of time and effort over the years to discussing midstream corporations and partnerships here at our service as well as on Seeking Alpha’s main site. As such, the majority of the largest positions in the fund will almost certainly be familiar. Here they are:

Franklin Templeton

With the notable exceptions of Western Midstream Partners (WES) and Plains GP Holdings (PAGP), I have discussed all of these companies numerous times over the years so they should all be fairly familiar. Plains GP Holdings is just the general partner of Plains All American Pipeline (PAA), which I have also discussed, so at least the basic fundamentals of the company should be somewhat familiar. For the most part, this is a very reasonable portfolio as many of these companies are among the best firms in the industry. In particular, MPLX (MPLX) and Enterprise Products Partners (EPD) both proved themselves as excellent companies during the challenges of 2020 and have earned a core place among the holdings of any energy income investor. We also see Targa Resources (TRGP), The Williams Companies (WMB), and Antero Midstream (AM) among the fund’s largest positions, which is quite reasonable as all three of these companies are positioned to profit from the growing demand for natural gas both domestically and around the world. We have discussed this numerous times over the past few years and have started to see it play out. According to the U.S. Energy Information Administration, U.S. natural gas consumption hit an all-time high in 2022:

U.S. Energy Information Administration

While the warm winter of 2022 and 2023 may have caused this trend to temporarily reverse, we will still probably see natural gas demand grow going forward. After all, the Farmer’s Almanac is predicting that this coming winter will be colder than the previous one and this will cause natural gas consumption to go up as people seek to heat their homes. We also have several liquefied natural gas plants coming online over the next few years that will increase natural gas consumption. This will benefit the midstream companies in this fund that have significant operations in the transportation and processing of natural gas such as MPLX, The Williams Companies, and Antero Midstream. This is because the rising demand for natural gas should mean that these companies will have to transport higher quantities of natural gas to get the resources to the end-user and the cash flows of these companies directly correlate to the volume of resources that they handle.

There have been relatively few changes to the fund’s largest positions since we last discussed this fund. In fact, the only major change is that Delek Logistics Partners (DKL) was removed from the list and replaced with Antero Midstream. Other than that, the weightings and general order of the companies on the list changed quite a bit but the companies themselves are the same names. This could simply be a result of one company outperforming another in the market. It is not necessarily a sign that the fund is engaging in trading activity to adjust the weightings in its portfolio. The fund only has a 43.00% annual turnover, which lends a certain amount of support to this conclusion. I explained why this is important in a previous article:

The reason that this is important is that it costs money to trade stocks or other assets, which is billed directly to the fund’s shareholders. This creates a drag on the fund’s performance and naturally makes management’s job more difficult. After all, the fund’s management must generate sufficient returns to cover the added expenses of the trading activity and still produce enough excess returns to satisfy the shareholders. There are very few management teams that manage to accomplish this on a consistent basis, which is one reason why most actively managed funds underperform their benchmark indices.

While the fund’s 43.00% annual turnover is not especially high for a midstream infrastructure fund, it is still quite a bit higher than the 26.00% turnover of the Alerian MLP ETF. As such, this fund will have somewhat higher trading expenses than a comparable index fund consisting of midstream partnerships.

Performance

With that said, the fund’s higher turnover has not apparently affected the fund too much. At least, it has not affected the fund that much on a short-term basis. As we can see here, the ClearBridge MLP and Midstream Total Return Fund has actually delivered a better price performance than the Alerian MLP ETF over the past year:

Seeking Alpha

As I have pointed out numerous times in the past though, price performance is not necessarily the best metric to use to evaluate these funds. This is because both the ClearBridge Fund and the Alerian MLP ETF have very high distribution yields, as do most master limited partnerships and midstream corporations. These yields put money into the pockets of investors and that is not reflected by looking simply at price fluctuations. For example, if an asset’s price stays flat but it gives you a 9% distribution then you still made money from that asset at the end of the day.

As such, let us have a look at the fund’s performance against the index once we add the distributions into the comparison:

Seeking Alpha

We can immediately see that both the ClearBridge MLP and Midstream Total Return Fund and the Alerian MLP ETF delivered very attractive total returns over the past year. The ClearBridge Fund actually beat the 15.97% total return of the S&P 500 Index (SPY) over the period, although the index fund lagged slightly. This is certainly the kind of performance that any investor should find to be very acceptable.

However, a single year does not tell us very much about the quality of a fund’s management or its performance. In addition, we like to hold our assets for extended periods of time so that we can get a steady stream of income and let the profits compound. Therefore, let us have a look at the past three years. Here is the ClearBridge MLP and Midstream Total Return Fund against the index and the S&P 500 Index for good measure:

Seeking Alpha

As has been the case with many of the other midstream funds that we discuss here, the ClearBridge Fund completely dominated both the Alerian MLP ETF and the S&P 500 Index over this period. Indeed, the S&P 500 looks like a straight line in comparison to either of the energy infrastructure funds.

With that said, looking at the past three years gives an unfair advantage to the energy infrastructure funds. This period puts the start date in September 2020, which was about the time that the economy was reopening following the COVID-19 pandemic lockdowns. As we can all recall, crude oil took off like a rocket pretty quickly as demand returned and it carried the beaten-down energy assets with it.

Let us look at the trailing ten-year period:

Seeking Alpha

I removed the S&P 500 Index from this comparison since it completely outperformed both funds on a total return basis and it skewed the chart and made it difficult to see exactly how the ClearBridge MLP and Midstream Total Return Fund compared to the Alerian MLP Index. In this case, we unfortunately see that the closed-end fund cannot even compete. As has been the case with most energy infrastructure closed-end funds, the two industry crises in 2015 and 2020 devastated the fund’s net assets to the point that they were unable to recover. Interestingly, we can see that the fund’s performance does almost perfectly track the index, except for those two years in which its declines were much more exaggerated than the index.

While past performance is no guarantee of future performance, we can draw one important conclusion here. The ClearBridge MLP and Midstream Total Return Fund will probably outperform the index during periods in which the energy industry is very strong. However, it will probably also deliver much larger losses during periods of market weakness. As such, this fund looks like a high-risk, high-reward way to play the midstream sector. I leave it up to the reader to decide if you are comfortable with that risk or would prefer the slightly lower yield of the Alerian MLP Index.

Distribution Analysis

One of the biggest reasons why investors purchase the common equity of midstream companies and partnerships is because of the incredibly high yields that these companies possess. Indeed, the Alerian MLP Index yields 7.92% at the current price. The ClearBridge MLP and Midstream Total Return Fund invests in a portfolio of these companies and collects the dividends and distributions that they pay out. The fund also engages in a certain amount of trading to (hopefully) generate capital gains. The collected distributions and capital gains can all be paid to the shareholders of the fund, net of the fund’s expenses of course. When we consider the high yields possessed by the companies in the fund’s portfolio and the capital gains on top of that, we can assume that it will have a very high yield itself. This is certainly the case as the ClearBridge MLP and Total Return Fund pays a quarterly distribution of $0.70 per share ($2.80 per share annually), which gives it an 8.73% yield at the current price. Unfortunately, the fund has not been particularly consistent with its distributions over the years, as we can see here:

CEF Connect

As we can clearly see, the fund has cut its distribution a few times over the past ten years, although it has recently started to increase it. This is almost certainly going to be something of a turn-off for those investors who are seeking a safe and secure source of income to use to pay their bills or otherwise finance their lifestyles. However, it is completely understandable that the fund would have to engage in these cuts due to the aforementioned problems that the energy sector endured in both 2015 and 2020. The fact that the fund has started raising its distributions again is something that we should be able to appreciate as it will help us overcome the deleterious effects of the high inflation currently plaguing the economy.

As is always the case though, it is critical that we ensure that the fund can actually afford the distribution that it pays out. After all, we do not want to be the victims of a distribution cut that reduces our incomes and almost certainly causes the share price to decline. Let us investigate its finances to determine this.

Fortunately, we have a fairly recent document that we can consult for the purposes of our analysis. As of the time of writing, the fund’s most recent financial report corresponds to the six-month period that ended on May 31, 2023. This is a much newer report than the one that we had available to us the last time that we discussed this fund. That is nice to see, as crude oil prices started to decline after peaking last November and remained suppressed over the first half of this year. This report should give us a good idea of how well the fund managed to perform in that market environment, which was understandably weaker than most of the rest of 2022.

During the six-month period, the ClearBridge MLP and Midstream Total Return Fund received $12,860,413 in dividends and distributions along with $96,553 in money market fund distributions from its cash positions. A significant percentage of the received money came from master limited partnerships, however, which is not considered to be investment income for tax purposes. As such, the fund only reported a total investment income of $2,749,264 during the period. As might be expected, this was not nearly enough to cover the fund’s expenses, and it reported a net investment loss of $5,232,955 during the six-month period. At first glance, this may be concerning as the fund clearly did not manage to achieve sufficient net investment income to cover its distributions.

However, midstream infrastructure funds frequently do not have sufficient net investment income to cover their distributions. One reason for this is that money that comes from master limited partnerships is not considered to be investment income. The fund received $10,096,749 from these companies, which was easily enough to offset all of its net investment losses. In addition to this money, the fund managed to realize some capital gains, although it did not do nearly as well as it did in 2022. During the six-month period, the fund reported net realized gains of $9,771,803 but this was more than offset by $21,712,214 in net investment losses. The fund paid out $7,662,532 in distributions during the period, so technically it did manage to cover its distribution out of net realized gains. Its net assets declined during the period though, as the fund reported a $28,116,650 decline in net assets after accounting for all inflows and outflows during the period. For the most part, though, the fund’s distribution appears to be fine. The fund’s net assets increased by $63,592,954 during the preceding full-year period, so all that the net asset decline accomplished was to offset some of the gains that the fund had over the December 2021 to November 2022 period. The decline that occurred during the most recent six-month period was primarily due to net unrealized losses, which can easily be reversed during a market rally. We definitely want to keep an eye on the fund’s finances, but there should not be too much to worry about here.

Valuation

As of September 18, 2023 (the most recent date for which data is currently available), the ClearBridge MLP and Midstream Total Return Fund has a net asset value of $38.25 per share but the shares currently trade for $32.28 each. This gives the shares an enormous 15.61% discount on net asset value at the current price. This is quite a bit better than the 13.05% discount that the shares have had on average over the past month. Honestly, though, any double-digit discount represents a reasonable price to pay for a closed-end fund. The price of this one is perfectly acceptable if you want it.

Conclusion

In conclusion, the ClearBridge MLP and Midstream Total Return Fund is a reasonable way to play the midstream sector. This could be a reasonable place to be right now considering that crude oil prices are poised to experience strength through the end of the year due to a very large global shortfall. This could be a long-term situation too, as the energy sector as a whole has been chronically underinvesting in production capacity for most of the past decade. The history of this fund suggests that it could be a high-risk, high-potential return way to invest in the sector though, so it might not be right for those investors that are highly concerned about preserving their capital. The current distribution and valuation are quite attractive though, so the fund might be worth it if you are willing to take the risk.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of MPLX either through stock ownership, options, or other derivatives. 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.

I am long various energy-focused funds that may hold any stock mentioned in this article. The holdings of these funds may change at any time without my knowledge or input. I have a direct long holding in MPLX. This article was originally published to Energy Profits in Dividends following the market close on September 19, 2023. Subscribers to the service have had since that time to act on it.

Comments

[papaone]

What difference do you find between EMO and this Clearbridge fund?
They appear to track out about the same and both have better results than other funds in the sector. Thanks, you do a great job as an analyst.

[Mawyai]

Thanks for the article. I wonder how this compares, to what looks like a similar play with KYN. I have had KYN, now north of 9% yield, for over 4 years. I have held despite getting burned during CV19 from high leverage and fees.

[Mawyai]

@Mawyai I also made this comment because I know you have written about KYN