With MLPs, Look Beyond High Yields

8/31/2009


Income-oriented investors facing minuscule yields on money-market funds may find the yields of Master Limited Partnerships (MLPs) enticing. However, before chasing those hefty yields, it’s best to learn the pros and cons of these investments.

MLPs are publicly traded partnerships that typically invest in hard assets — real estate, commodities, or energy-related assets like pipelines and storage facilities. Because of its structure, an MLP does not pay income taxes. Rather, income, depreciation, and expenses are “passed through” to partners (i.e. unit holders) based on their ownership stakes. The unit holders, in turn, are responsible for their own tax reporting.

Similar to real estate investment trusts (REITs), MLPs distribute the bulk of their cash flows to partners. Thus, yields tend to run well above those of common stocks.

However, there is no free lunch when it comes to MLPs.

Market volatility. It doesn’t do you much good if an investment yields 10% but declines 40%. That was the case for many MLPs in 2008. As the chart on page 2 shows, the Alerian MLP Index, which consists of 50 prominent energy partnerships, fell more than 41% in 2008. The group has rebounded sharply since March. Still, investors should not ignore the potential volatility. Liquidity also affects MLP prices. Many of the smaller partnerships may not have large trading volumes, and prices may adjust down during market pullbacks to reflect that lack of liquidity.


ALERIAN MLP INDEX


Interest-rate sensitivity. Because of their high income streams, MLPs can behave similarly to fixed-income investments, reacting negatively when interest rates rise.

Need for credit. Many MLPs in capital-intensive sectors, such as energy distribution and storage, must access credit markets to fund expansion. If that access is impinged — as happened during the 2008 credit-market meltdown — MLPs could suffer.

Economic sensitivity. One of the appeals of certain energy MLPs, especially those involved in natural-gas distribution and storage, is that their cash flows are not especially sensitive to energy prices. In fact, low natural-gas prices can sometimes spark greater demand for distribution and storage. However, economic weakness affects end-user demand for energy products, which impacts MLP volume and revenue regardless of commodity prices. And that ultimately could lead to lower distributions to unit holders.

Potentially complex tax issues. As mentioned earlier, investors in MLPs are limited partners, purchasing units rather than traditional shares. MLPs report tax information to unit holders via annual “K-1” statements. These partnerships pass depreciation and other expenses through to investors, who may be able to use them to reduce or eliminate taxes on income from the MLP. However, you may lose that tax advantage for MLPs held in IRAs. In fact, MLPs sometimes throw off cash flows deemed “unrelated business taxable income.” Investors may owe taxes on such income even if the MLP is held in an IRA. Adding to the complexity, some larger investors may have to pay taxes in the various states where the partnership operates. Bottom line: Talk to your tax adviser before you invest in MLPs to avoid surprises.

The Forecasts does not recommend any MLPs at this time, as most high scorers in our Quadrix® universe have market capitalizations below our preferred threshold. However, our sister newsletter that focuses on small and midcap stocks, Upside, does recommend one MLP.

Suburban Propane Partners LP ($41; SPH) distributes energy products, primarily propane, to approximately 1 million residential, industrial, and agricultural customers in more than 30 states. The company controls roughly 5% of the national propane market and will likely lift that share via acquisitions.

In August, the company issued 2.2 million new units, boosting outstanding units by 7%. Suburban Propane plans to use the proceeds to pay off debt. The unit price fell on the news, and the pullback looks like a buying opportunity. Suburban Propane yields 8.0% and represents a solid pick for income-oriented investors.


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