When investors evaluate fixed-income assets, the rule of thumb is “the higher the yield, the higher the risk.”
But with higher-yielding strategies like dividend-paying stocks, real estate investment trusts and master limited partnerships, it gets more complicated: “The less secure the yield — be it as dividends or MLP distributions — the higher the risk.”
Naturally, the question arises: How does one evaluate such yields — particularly with a likely dividend tax hike just a few weeks away?
Many yield hunters have more or less forgotten the basic concepts of capital structure. Shareholders own and bondholders lend, or that dividends are at discretion of the board while bond interest in an obligation. Many investors, prodded by the Federal Reserve out of the bond market thanks to numerous rounds of quantitative easing, have been hiding in dividend-paying stocks, MLPs and REITs only to get caught a bit flat-footed by the impending fiscal cliff.
Their post-election reaction? They have been selling. Why? Because the tax rates on dividends and capital gains are set to head higher.
While it is impossible to predict what type of compromise, if any, the White House and Congress will have in the next three weeks, it is possible to figure out a winner on this investment tax hike situation: MLPs.
MLPs, unlike corporations, have no taxes on distributions to shareholders, so there is no real fiscal cliff tax effect (other than the one brought on by panicky sellers who have not done their homework). While MLPs trade like stocks on an exchange, their shares are referred to as units and their shareholders as limited partners. The “dividends” in this case are called “distributions,” and they are paid every quarter just like regular dividends.
Dividends currently are taxed at a 15% rate, but MLP distributions are taxed at the individual’s marginal tax rate, as there is no corporate double taxation. Limited partners holding MLPs in taxable accounts can also use depreciation charges from the MLP to decrease their individual tax liability.
Most MLPs are concentrated in the energy sector and typically are fee businesses that have to do with the transportation and processing of commodities, and they typically have to distribute all of their available cash to unitholders.
MLPs also have seen a windfall in recent years from shale oil and gas exploration as rising domestic volumes have meant more income for existing pipelines, as well as processing and storage facilities. Domestic production is expected to continue to climb, with U.S. energy independence possible by 2020 given current trends — which is why most MLPs transporting energy are in a long-term bull market.
Still, despite no fiscal cliff tax effect, MLPs did sell off after President Obama won the election. But why?
I have been around financial markets for 15 years, and if I have learned anything, it’s that the efficient market hypothesis is pure baloney. There is no such thing as a completely rational market reaction; in rare occasions, the market can swing all the way to pure irrationality.
My favorite example in the sector is an MLP called Teekay LNG Partners (NYSE:TGP) — an MLP operates primarily liquefied natural gas (LNG), liquefied petroleum gas (LPG) and some oil tankers leased at long-term contracts with no exposure to the spot market.