It’s time to answer the “who, what, when, where, and why” of investing in master limited partnerships (MLPs)…
Andrey Dashkov, senior research analyst at Miller’s Money Forever, is the rare person who, when you asked for a hammer comes back with a hammer, nails, staples, and glue. In short, he often comes up with better solutions to tricky problems than I ever thought possible.
Since Andrey and I are on a nonstop mission to unearth the best opportunities for generating safe income, we have looked to MLPs more than once. Many Business Development Companies (BDCs) and Real Estate Investment Trusts (REITs) also fit the bill.
Today, however, we are focusing exclusively on how MLPs can produce a healthy and steady income without exposing your nest egg to unwelcome risks.
The Nuts and Bolts of MLPs
By Andrey Dashkov
An MLP is an entity structured as a limited partnership instead of the traditional C-corporation. This allows the company to avoid corporate-level taxes. The limited partners pay most of the taxes, which means that MLPs are essentially pass-through entities.
In the United States, the net effective rate of corporate income tax is 40%. That means a corporation calculates its profit, pays the appropriate income tax to the government, and then pays dividends from what remains. With an MLP all the profits are passed through to the unit holders.
While a traditional corporation can choose to pay a dividend, an MLP does not have that option. In order to maintain their status, MLPs are required to generate at least 90% of their income from qualifying sources and distribute the major portion of that income. In most cases these sources include activities related to the production, processing, and distribution of energy commodities, including gas, oil, and coal.
The government gives a special treatment to these activities to encourage investment into the United States’ energy infrastructure.
Limited partners (LPs) own the company together with a general partner (GP). The GP takes care of the day-to-day operations, typically holds a 2% stake, and can usually receive incentive distribution rights (IDRs). LPs, called unit holders, (which we can become by buying shares of publicly traded MLPs) receive dividend-like cash distributions. LPs, unlike traditional shareholders, do not have voting rights.
There are many advantages to MLPs, including:
- Attractive yields;
- Inflation protection;
- Portfolio diversification;
- Tax advantages; and
- Resilient business model.
Let’s take a look at each of these advantages:
MLPs pay various yields that average 5-10%. Data for the Alerian Index, which tracks the top 50 MLPs, show that in Q2 2013 MLP yields varied from 3-12%, with an average of 6.5%.Besides the actual yield, MLP investors can count on distribution growth. Dividends per share of Alerian Index constituents grew at a compounded rate of 4.1% over the past five years.
Several factors hedge against inflation:
- Inflation-adjusted contracts renewed periodically;
- Distribution growth has historically outpaced the growth in CPI; and
- MLP unit (share) prices are weakly correlated with movements in inflation and interest rates.
MLPs have a low correlation to other asset classes, including equity, debt, and commodities. However, for a short time they may correlate with any asset class or the market in general.
MLPs are less volatile than the broad market. Currently at 0.5, the average beta of Alerian Index, is quite conservative. This suggests that if the broad market goes down by 10%, we should expect the Alerian Index to drop by 5%. An individual company’s volatility may stray from the average, but in general MLPs should be much less volatile than the market as a whole.
Generally, the vast majority of MLPs operate in the energy sector, but usually do not own the underlying commodities; this is part of the reason for the decreased volatility. Their income generally consists of transportation fees. However, some MLPs can be exposed to commodity risk (coal, propane, and oil exploration and production MLPs, among others). Economy-wide consequences of a severe recession may impact the demand for energy commodities and, in turn, the profitability of transportation companies.
An MLP investor typically receives a tax shield of 80-90% of one’s annual cash distributions, which is a very nice feature. This defers tax payments until the unit (your share) is sold.
The tax payment schedule for an MLP is illustrated below. Assume you bought one unit of an MLP for $20 and sold it after five years for $22, having received $2 annually in years 1-5. Assuming your ordinary income tax is 35%, and the long-term (LT) capital gains are taxed at 15%, you can see the breakdown.
|Year 0||Year 1||Year 2||Year 3||Year 4||Year 5|
|Distribution per unit||$2.00||$2.00||$2.00||$2.00||$2.00|
|Income per unit||$2.00||$2.00||$2.00||$2.00||$2.00|
Earnings per unit
|Amount subject to ordinary tax rates||$0.40||$0.40||$0.40||$0.40||$8.40|
Ordinary tax rates
|Taxes owed at ordinary rates||0.14||0.14||0.14||0.14||2.94|
|Amount subject to LT capital gains||$2.00|
LT capital gains rate
|Taxes owed at ordinary rates||$0.30|
|Total taxes owed||$0.14||$0.14||$0.14||$0.14||$3.24|
|Source: Credit Suisse|