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Rising Rates And MLPs: Not All Bad News

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Rising Rates And MLPs: Not All Bad News

Master limited partnerships (MLPs) are often lumped in with other income-generating asset classes, such as the telecommunications and utilities sectors as well as real estate investment trusts (REITs). Along with their reputations for high yields, the aforementioned groups are also viewed as sensitive to rising interest rates.

These days, interest rates are rising. The Federal Reserve has boosted borrowing costs four times since the start of 2017 and some fixed income market observers believe the central bank has two or three more rate hikes left to deliver before the end of 2018. Those expectations have 10-year Treasury yields flirting with the psychologically important 3% area.

The knee-jerk response to rising Treasury yields is that those higher yields are burdensome for MLPs, REITs and utilities. Focusing on MLPs, it is worth acknowledging that the correlation between the asset class and U.S. interest rates from 2006 through 2016 was not as intimate as many investors may believe.

Initial moves higher by interest rates usually prompt short-term weakness in MLPs and energy infrastructure names, but there is another side to the story. Improving economic fundamentals, which contribute to higher interest rates, bolster the case for the energy sector. Various fundamental factors underscore the case for MLPs.

“MLP valuations appear cheap, and U.S. energy production is thriving, lifting cash flows for pipeline firms,” reports Barron’s. “Domestic oil production recently hit a record high of 10.5 million barrels a day. Natural-gas production is also booming, thanks to strong demand from utilities, petrochemical companies, and foreign nations.”1

Speaking Of Fundamentals…

When oil prices started faltering in late 2014, U.S. output and pipeline utilization declined. Exacerbating that situation, between 2015 and 2017, an array of new projects were completed, bringing excess capacity to market.

During that cycle, many MLPs became highly levered and depended on dilutive equity offerings to finance distributions and other capital spending. Increasing leverage among the asset class also stoked fears of MLPs’ vulnerability to rising rates. Following a spate of distribution cuts during the most recent oil bear market, many MLPs have shifted to less opaque, improved business models.

“MLPs have increasingly transitioned towards what we believe to be a better model (MLP 2.0),” said Cohen & Steers. “This begins by eliminating the general partner/limited partner/incentive distribution rights structure, improving corporate governance and creating better alignment of interests. It changes the mindset for capital allocation, allowing companies to set sustainable distributions and fund growth projects internally. For the first time, management teams are able to sell assets or execute share buybacks, putting the focus on generating attractive returns on invested capital, in our opinion.”2

Soaring U.S. natural gas and oil output potentially adds to the case for MLPs. The U.S. is pumping oil at its highest levels in nearly four decades and is in position to topple production titans such as Russia and Saudi Arabia for the title of world’s largest oil producer.

Related: The Trend is Your Friend in This Momentum ETF

An Infrastructure Idea

With production in the Permian Basin surging and the energy sector responding to higher prices, showing some resilience to higher interest rates along the way, the current environment could be conducive to revisiting energy infrastructure investments.

The Alerian Energy Infrastructure ETF (ENFR) tracks the Alerian Energy Infrastructure Index (AMEI), which is equally divided among U.S. MLPs, U.S. general partners and U.S. and Canadian energy infrastructure companies.

At the end of April, AMEI’s yield was 365 basis points above the yield on 10-year Treasuries and the index was positive in 71% of April’s trading days, according to Alerian data.

ENFR Performance >>

ENFR Holdings >>

1 Source: Barron’s April 21, 2018: https://www.barrons.com/articles/mlps-look-attractive-again-and-yield-as-much-as-8-1524270733
2 Source: Cohen & Steers https://s3.amazonaws.com/cohenandsteers-production/assets/content/resources/insight/VP663_The_Midstream_Energy_Cycle_Has_Turned.pdf
Important Disclosures & Definitions
An investor should consider investment objectives, risks, charges and expenses carefully before investing. To obtain a prospectus, which contains this and other information, call 1.877.398.8461 or visit www.alpsfunds.com. Read the prospectus carefully before investing.
Shares are not individually redeemable. Investors buy and sell shares on a secondary market. Only market makers or “authorized participants” may trade directly with the Fund, typically in blocks of 50,000 shares.
Investments in securities of MLPs involve risks that differ from an investment in common stock. MLPs are controlled by their general partners, which generally have conflicts of interest and limited fiduciary duties to the MLP, which may permit the general partner to favor its own interests over the MLPs.
A portion of the benefits you are expected to derive from the Fund’s investment in MLPs depends largely on the MLPs being treated as partnerships for federal income tax purposes. As a partnership, an MLP has no federal income tax liability at the entity level. Therefore, treatment of one or more MLPs as a corporation for federal income tax purposes could affect the Fund’s ability to meet its investment objective and would reduce the amount of cash available to pay or distribute to you. Legislative, judicial, or administrative changes and differing interpretations, possibly on a retroactive basis, could negatively impact the value of an investment in MLPs and therefore the value of your investment in the Fund.
The fund invests primarily in a particular sector and could experience greater volatility than a fund investing in a broader range of industries.
The Fund may be subject to risks relating to its investment in Canadian securities. Because the Fund will invest in securities denominated in foreign currencies and the income received by the Fund will generally be in foreign currency, changes in currency exchange rates may negatively impact the Fund’s return.
Investments in the energy infrastructure sector are subject to: reduced volumes of natural gas or other energy commodities available for transporting, processing or storing; changes in the regulatory environment; extreme weather and; rising interest rates which could result in a higher cost of capital and drive investors into other investment opportunities.
The Alerian Energy Infrastructure ETF is not suitable for all investors. Subject to investment risks, including possible loss of the principal amount invested.
Basis point: a unit of measure used in finance to describe the percentage change in the value or rate of a financial instrument.
ALPS Portfolio Solutions Distributor, Inc. is the distributor for the Alerian Energy Infrastructure ETF, Alerian MLP ETF, ALPS | Alerian MLP Infrastructure Index Fund and ALPS | Alerian Energy Infrastructure Portfolio.
ALPS Portfolio Solutions Distributor, Inc. is not affiliated with Alerian.
ALR000707 12/31/2018
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