MLPs: The Low-Risk, High-Yield Investment You've Never Heard Of
Last month, Finland joined Germany and the Netherlands in offering government bonds with negative-yields -- they pay back less than you pay for them. The upside, presumably, being that you'll only lose a little money.
It could be worse.
In this country, it's not quite that bad, but U.S. treasuries and bonds -- which have been for decades viewed as a safe bet to get modest returns -- aren't returning enough to beat the 2% annual inflation rate. In essence, that means they're a guaranteed losing investment, too. But a poor return on investment, we are told, is the price for safety.
It doesn't have to be.
U.S. savers looking for better ways to capture profits can find them with a little creativity, and by looking beyond the traditional government-backed safe havens.
Consider, for example, this option that many investors aren't even aware of: the Master Limited Partnership, an increasingly popular high-yield investment vehicle in which 80% of income is tax-shielded. They're good for income-oriented investors, and also a smart buy for young people looking for defensive securities.
You Down with MLPs?
MLPs have the tax benefits of a limited partnership, but with the liquidity found in publicly traded securities. Investors -- known as unit holders -- purchase units of the partnership -- similar to shares of a stock -- through holding companies, and get paid quarterly distributions that are similar to dividends.
One big MLP advantage stems from the fact that the partnerships are mostly "pipeline"-related -- those involved with the transport or extraction of oil, natural gas or natural gas liquids. That's been key to their consistently impressive performance.
"Investors have this thirst for income," said Maury Fertig, CIO of Relative Value Partners in Northbrook, Ill. "For someone who wants income, but realized the bond market is not there, if they're willing to take a little risk, they're constructing a scenario where they can dip a toe in the market."
Think of MLPs as a hybrid between fixed-income instruments and equities: They have both high current income yields and stable, growing distributions, and have outperformed the S&P 500 in 11 of the last 12 years. There's also a low correlation of MLPs to equities, commodities, and fixed-income instruments -- in other words, they do well when those assets aren't, so they're good for portfolio diversification.
And MLPs provide a yield significantly higher than more well-known income-focused investments like utilities and REITs. At the end of the second quarter, MLPs had yields of 6.7%, compared to utilities at 4.1%, REITs at 3.4%, the S&P 500 at 2.2%, and 10-year Treasury bonds at 1.6%.
It's the MLP distributions, with their consistency and robust growth, that drive the investment's performance and make it a better hedge against inflation. "Your brokerage distribution drives half of your returns," explained Darren Schuringa, managing member at Yorkville Capital Management LLC in New York City.
The sort of distribution growth MLPs provide usually comes with some degree of compromise or risk -- but MLPs have been largely immune to that.
"More income usually means more risk [in an investment]," Schuringa said. "But distributions with MLPs have been more stable than REITs and utilities. There's no more risk of default or volatility in distribution. This would usually be indicative of a mispriced asset class, but it's not in this case."
How Do I Invest In MLPs, and Why Are They So Secure?
Any time someone starts telling you about an investment opportunity that has high returns and low risk, a wise investor will suspect something's fishy. But in the case of MLPs, this rare pairing of qualities has a reasonable explanation.
MLPs are both hot and stable right now because they're profiting from a major U.S. energy extraction boom. Fracking and horizontal drilling efforts have tapped into new reserves in shale gas, as in North Dakota's Bakken formation -- discoveries that bode well for attractive returns in energy sector-heavy MLPs.
Many MLPs are invested in providing infrastructure to move oil and gas. Kinder Morgan (KMP), for example, is an MLP, and a natural gas pipeline operator. Think of it as a toll collector, earning fees from large energy companies for transporting their products.
Pipelines are a much more predictable business than extraction: They're far less subject to troubles when commodity prices fall, nor do they have to worry about the risks taken on buy those companies that drill for -- and sometimes fail to find -- oil or natural gas. And because regulatory approvals for new pipelines are hard to come by, these MLPs will have a virtual monopoly in the business for quite some time. For now, natural gas prices are strong, and -- another auspicious sign -- the crude oil to natural gas price ratio remains near its all-time high.
The Tax Benefits
Income from MLPs is tax-deferred, and given the fiscal cliff the U.S. is facing, that makes them a partial shield against potential upticks in the marginal tax rate.
MLP distributions are tax-advantaged because of a quirk in their corporate structure: They require a lot of capital expenditure, which gives them a huge shield of depreciation. Depreciation becomes an "expense," and because it appears on paper as greater than revenue, partnerships can show a loss on paper even though they are generating a lot of cash-flow. The partnership thus has money to distribute to its unit holders, 80% of which counts as tax-defered return on capital and not as current income.
"It's a tremendous advantage given the economic uncertainty we're facing in the U.S. now," Schuringa said. "If nothing happens, taxes are going to go up ... on distributions and capital gains."
"Investors should be putting assets into vehicles that will shield them from rises in the marginal tax rate," Schuringa said.
"From an investing perspective," he said, "no matter what happens with the election, I can sleep tight at night as long as these companies tend to pay their distributions."