Pipeline MLPs are one of the most universally loved segments of the market right now, and with good reason. The combination of high dividend yields, steady cash flows and improving growth prospects — stemming from increased North American natural gas production — has sparked tremendous gains in the sector during the past three years. The Dow Jones U.S. Pipelines Index (DJUSPL) is up 240% since early 2009, and its 50.13% gain in 2011 made it the top performer out of 99 industry groups for the year.
But now that these substantial gains already are in the books, investors would be prudent to begin exercising a measure of price sensitivity with regard to the MLPs.
There’s an important reason why this is so: Prices have come so far in the past 12 to 18 months that yields for many MLPs are now exceptionally low compared to historical levels. With yields averaging out to the mid-5% range for the largest MLPs, this group still can provide investors with a much higher yield than the 1.9% available on the 10-year Treasury note.
Still, the spread over Treasuries is well below its average of the past decade due in part to the rapidly growing popularity of this sector. MLPs have received a substantial amount of media attention in recent years, almost always with a positive slant through the countless articles highlighting the income opportunities available in this sector. During 2011, in fact, the Alerian MLP ETF (NYSE:AMLP) received the fourth-highest net inflows of any ETF in the U.S. market.
Click to Enlarge This is a potential problem, for two reasons:
First, there is now quite a bit of “dumb” money in this sector that will have little tolerance for adverse developments, which creates the potential for outsized downside on relatively benign news. A prime example: Last Thursday, technical analyst Carter Worth went on CNBC’s Fast Money and stated his belief that Kinder Morgan Energy Partners (NYSE:KMP), the largest pipeline MLP, was overbought. Although only 219,000 viewers watched the episode, KMP fell as much as 3.9% at Friday’s intraday low before recovering to close the day with a loss of 1.7%. The lesson is that a minor news event led to an outsized downturn — an indication that extreme caution is warranted right now.
Second, the MLPs’ yields have fallen low enough that other asset classes are now posing stiffer competition. The 10 largest MLPs have an average yield of 5.5%. While still higher than most asset classes, this yield figure is about 1.3 percentage points below what is now available in high-yield bonds, and only about one percentage point above emerging-market bonds. Another example of this trend can be seen in the JPMorgan Alerian MLP ETF (NYSE:AMJ), which is now yielding 4.98% — less than half a percent above the 4.51% yield of the Select Sector Utilities SPDR (NYSE:XLU). The takeaway is that MLP yields are starting to drop into a more crowded neighborhood, which could put a damper on incremental demand.
The bottom line: the MLPs still have a lot going for them, but the combination of the tremendous recent price action and the low historical yield levels indicate that investors need to be very mindful of the potential risks. If you already are in Kinder Morgan or any of the names in the charts below, consider taking steps to protect your position. If you aren’t, be patient — there likely will be an opportunity to get into this sector at a lower price in the weeks and months ahead.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.