Written by: Andrea Coombes | ALPS
For most investors, the initial appeal of master limited partnerships, or MLPs, is their potential to produce steady income over time. After all, these unique instruments—the majority of which deal in the pipelines that transport oil and natural gas—historically have offered a consistent annualized yield of about 6%*.
Yet the benefits of MLPs go beyond their income-producing qualities alone. In fact, MLPs exhibit some of the qualities of fixed-income, real assets and equity investments, combined. While the value of bonds can be eroded by rising interest rates, MLPs generally exhibit a resistance to that concern. MLPs also have potential inflation protection, with their income stream generally closely aligned with increases in costs. Finally, MLPs are equities, traded on exchanges, and their total returns are in line with those of traditional equities. In other words, MLPs have some benefits of equities, real assets and bonds.
But, you may well ask, why now? What is it about 2017 that makes MLPs a particularly attractive investment this year? Let’s look at three main reasons.
The first is a recent improvement in valuations, which for several years have been an Achilles’ heel for MLPs. Initially, MLPs were overpriced—a situation that changed dramatically in November 2014, when oil prices plunged on the Organization of the Petroleum Exporting Countries, OPEC’s refusal to cut output. Through February 2016, generalized investor fear characterized the performance of all energy asset classes, regardless of where the assets existed in the energy supply chain. No more. The Great Reset is underway and for the first time in years, MLPs are trading close to historical averages, a sign that the fundamentals in the asset class have improved. Valuations are still relatively low cost, but not so low cost that inherent risks rise to the forefront. MLPs are starting to trade as they should.
Relatedly, MLP price correlations to crude oil have improved. While oil and MLPs were trading in tandem early in 2016, that has since changed – as it should. Think about it: This asset class operates to some degree like a toll road, transporting crude oil and natural gas from Point A to Point B. On a toll road, a Honda Civic pays the same toll as an Aston Martin. That is, no matter what the price of the commodity, it pays the same toll. What matters is volume. And on that score, for better or worse, the demand for energy in the U.S. is inelastic. Whether oil is $30 a barrel or $130, we continue consuming it. Thus, MLP prices shouldn’t be that closely tied to oil prices—and, in an encouraging sign for investors, that correlation started to dissipate at the end of 2016.
The second reason to be optimistic regarding MLPs in 2017 is the likelihood of higher interest rates. While investors often assume any income product will be sensitive to higher rates, MLPs are remarkably resistant to such rises over the long haul. (That said, rate-hike fears have been known to punish MLPs in the short term.) The 10-year Treasury almost doubled from July to mid-December last year, sparking carnage in the bond market, yet MLPs saw positive returns. MLPs are typically resilient to rising interest rates for two reasons: They have the ability to grow their cash flows—historically at a 6% to 7% annualized clip—which helps them keep up with rising rates, unlike a bond or fixed-income investment. The second reason is their yield is high enough to provide some cushion. Take the current situation: MLPs are yielding about 7%* currently, while the 10-year Treasury offers about 2.4%*. MLPs have a built-in yield cushion, much more so than REITs or utilities.
The third potential opportunity in 2017 is President Donald J. Trump. His precise actions as president are difficult to predict, but generally he seems to be constructive on infrastructure, and specifically energy infrastructure. The potential for additional energy investment, combined with a reduction in government regulations would be beneficial to MLPs. While most regulation of MLPs occurs at the state level, there is some federal oversight. That said, it’s prudent to be cautious in uncertain times.
Speaking of being prudent, be sure to consider MLPs in the proper context for your portfolio. Given that these are equities, the likelihood of greater volatility in 2017 shouldn’t be underestimated. When considering MLPs in your asset allocation, source your investment via the equity side of your portfolio. (We like to call MLPs an income alternative, rather than a fixed-income alternative.) Doing so creates a portfolio with higher yield, better diversification and similar total return expectations to other equity investments.
*Source: Bloomberg, 12/31/2016
Disclosures and Definitions
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. The benefit 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.
correlation: statistic that measures the degree to which two securities move in relation to each other.
annualized clip: calculated as the equivalent annual return an investor receives over a given period of time.
yield cushion: overweighting strong sectors for protection wen interest rates fluctuate.
For additional information, please visit www.alpsfunds.com.
ALPS Portfolio Solutions Distributor, Inc. and IRIS.xyz are not affiliated.
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