Yield Hunters: Ditch Bonds, Seek Out MLPs

by Lawrence Meyers | October 3, 2012 11:00 am

Bonds stink. That stupid Fed is keeping interest rates down to try to stimulate the economy, and it’s mucking up my hunt for yield! Fortunately, there are plenty of other income investments out there, and I want to point out some really safe and juicy ones.

Master limited partnerships were created by Congress in 1987 to spur investment in the energy sector, but only for companies engaged in “the exploration, production, mining, processing, refining, marketing or transportation of mineral and natural resources.” That’s just fine with me, because I prefer infrastructure plays over direct investments in the commodity they service. This makes MLP cash distribution payments more reliable. In addition, there always will be demand for energy, no matter what happens to the world economy.

But there are a few things things to keep in mind regarding risk:

• If credit tightens again or the secondary market weakens, MLPs with the weakest cash positions might not survive because they need to constantly put some money into capex.
• The second is MLPs must issue Schedule K-1 tax documents every year, and even if you sell an MLP stock at a loss, you might get an unwelcome surprise when your K-1 arrives and it shows income allocated to your shares — even if you never actually received any.
• Finally, distributions paid by MLPs into retirement accounts are taxable, so check with your tax adviser before placing MLP investments in your retirement account.

The king of this sector is Kinder Morgan Energy Partners (NYSE:KMP[1]). The company’s distribution history has been stable and predictable, even increasing over time, with negligible impact during the financial crisis. Kinder Morgan Energy Partners has a current yield of 6%. Analysts suggest it will grow 22% annually over the next five years. KMP is arguably overpriced, but it is so conservatively run and has very manageable debt service, with such great cash flow, that I think it’s a buy even here at $84.

El Paso Pipeline Partners (NYSE:EPB[2]) struggled a bit in 2009, recovered in 2010, and finished 2011 with $480 million in free cash flow. It already has generated $270 million through the first half of this year. Although it carries $4.5 billion in debt, the interest expense is negligible (under 2%). It has a stellear net margin of 28%, almost twice that of Kinder Morgan. The play here is on storage and transport of natural gas, whereas Kinder is more diversified across operating oil fields, as well as transporting energy around. El Paso yields a nice 5.9% in distributions.

Spectra Energy Partners (NYSE:SEP[3]) is my other selection here. The company managed $140 million in FCF even during a tough 2009, bumped it to $160 million in 2010, then went crazy on capex in 2011 — spending four times what it did in previous years. Spectra still ended with $120 million in FCF last year, and the capex set the company up for what so far has been $100 million in FCF through just the first half alone. The company’s 6.1% yield is just skirting by what’s possible, as the company is paying out almost everything it makes in terms of operational cash flow. So while it’s possible that distribution might fall a bit, the capex SEP plowed into the business in 2011 has given it a lot of extra cash-flow-generating ability.

As of this writing, Lawrence Meyers[4] did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc.[5], which brokers secure high-yield investments to the general public and private equity. You can read his stock market commentary at SeekingAlpha.com[6]. He also has written two books[7] and blogs about public policy[8], journalistic integrity[9], popular culture[10] and world affairs[11].

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