Gil’s Musings

Why It Still Makes Sense to Buy MLPs

Master limited partnerships are among the hottest trends in the investing marketplace these days. At least 16 MLPs have filed or announced plans to file for initial public offerings so far this year. That’s more than all the MLP IPOs in 2007. It’s easy to see why investors love MLPs. So far this year, the Alerian MLP index, the sector’s benchmark, is yielding about 5.8%, compared with 2.1% for the Standard & Poor’s 500 Index. If you had invested $1,000 in the 50 companies of the Alerian index in 2009, today you would have about $4,000. The same amount invested in an S&P Index fund would be worth about half as much.

But the appeal of MLPs is greater than that.

Normally, I don’t believe in chasing investment trends, but in this case, I believe MLPs remain a solid investment option, one that will persist at least for the rest of the year. To understand why that’s the case, let’s take a look at how MLPs work and what makes them so appealing at the moment.

Unlike corporations, MLPs are structured so that they earn at least 90% of their income from activities related to natural resources, commodities or real estate. Most MLPs these days are in the energy sector, primarily pipelines and natural gas storage.

The partnership structure comes with certain tax benefits. Unlike regular corporations, MLPs don’t pay income tax at the company level. This is good for the partnership because it lowers its cost of capital, and it’s good for investors because it eliminates the double taxation of dividends. The tax liability is passed through to the investors, known as unitholders. Some portion of the income from each investor’s share of the partnership’s net income is taxed at the investor’s individual income tax rate.

But there’s an even bigger benefit for investors. Due to depreciation and other factors affecting the taxes normally paid by companies, large portions of the payments to investors from MLP’s might not even be taxable until the units are sold. Not only does this enhance compounding by deferring taxes, this might also convert current income into a future capital gain, and long term gains are capped at just under a 24% tax rate. Remember also that if any owner dies with an untaxed gain, the estate or spouse inherits the units with the gains erased, possibly making the periodic payments untaxable forever. Check with your tax advisor.

Part of the reason for the rising popularity of MLPs in recent years has been the ongoing renaissance in the American energy business. Booming oil and natural gas production in the U.S. has increased the need for pipelines and storage facilities, whose cash-flow businesses are ideally suited for the MLP structure. This points to another advantage of MLPs: they offer investors a great way to benefit from increased oil and gas demand, without being exposed to the volatility of commodity markets or even energy-related stocks.

An MLP holding natural gas pipelines, for example, derives its income from “tolls” collected for shipping gas through its pipeline network. Those tolls are collected at regular intervals regardless of the price of the commodity being shipped.

In the past few years, as speculation has mounted that the Federal Reserve will raise interest rates, there’s been growing concern that MLPs may lose their appeal. MLPs frequently tap capital markets to raise funds for pipeline expansions, acquisitions and other projects. Higher interest rates would make this capital more expensive and raise the MLP’s overall costs, reducing the distributions to investors. MLP’s are also priced in the marketplace based on the appeal of their cash payments to unitholders. As interest rates rise, lower share prices might be needed to maintain a competitive yield, since the distributions would be somewhat fixed.

While a spike in interest rates could dampen MLP returns, I don’t believe interest rates will rise enough in the near future to pose a significant risk to MLP investors. In fact, I continue to buy MLPs because I believe they offer investors an opportunity for better-than-average returns combined with lower taxes. While recent economic indicators may encourage the Fed to raise rates, MLP returns are likely to continue outpacing stocks for some time.

While the strong investor demand we’ve seen for MLPs in recent years might make it feel like the sort of investing fad I’d normally urge investors to avoid, I believe MLPs remain a smart choice.

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