Whither income-oriented investments — or is it wither?
Investors living on the proceeds of their investments face hard times, as many retirees are fast discovering, while watching their monthly checks dwindle.
Money market yields offer thin fare (below 1 percent in most cases) and 10-year Treasuries yield below 4.5 percent. True, higher-yielding REITs offer an alternative, but many signs point to the possibility of a REIT-damaging real-estate bubble-burst.
Given all this, what's an income-seeking investor do? Some suggest looking at master limited partnerships (MLPs).
What are MLPs?
Devised in the 1980s, MLPs offer investors high yields and the tax advantages of a limited partnership, along with the liquidity of a publicly traded stock. To be more specific, they are vehicles of asset securitization, typically proffered by oil and gas companies as part of a bid for favorable tax treatment. The MLPs are often based on spun-off midstream assets related to the companies' pipeline operations.
Investor interest in MLPs has risen sharply, and continues to do so. Over the last six years, total MLP capitalization has increased to $36 billion from $5 billion. This popularity is based in large part on MLPs' excellent recent performance. Through midyear 2003, pipeline-MLP indices returned about 28 percent, roughly twice the 14 percent gain of the S&P 500, and alert investors snapped up nearly $2 billion of MLP units in that time frame, compared to $1.9 billion for all of 2002.
Does that mean new investors would be arriving late to the sector? According to Mark Easterbrook, analyst with RBC Capital Markets, probably not.
“We don't have undervaluation, but we don't have overvaluation, either,” he says. “The yield spread to the 10-year Treasury has narrowed, but it's still around historical levels.”
Indeed, the heavy investment flow into MLPs may well continue, given the high yields and tax shields that they provide. The spread between the average MLP and the Treasury yield is currently about 2.6 percent, slightly above the historical level of 2.4 percent.
With the 10-year yielding 4.3 percent, the average MLP returns slightly below 7 percent. About 80 percent of this the investor keeps, since an MLP distribution (it's not called a dividend) is usually treated as return of capital, not income. Translation: Investors net around 5.6 percent, on average.
In addition to the tax advantages, many investors see MLPs as a diversification tool. By adding MLPs to their stock portfolios they can lower their exposure to volatility in the equities markets. According to Lehman Brothers research, over the past five years, the correlation of MLPs to the S&P 500 has been a mere 19 percent.
A Steady Flow
Another benefit of MLPs is that they are based on a very reliable business model. Pipeline assets are highly capital intensive and they boast strong barriers to entry and low variable costs. In addition, incremental margins tend to be high.
According to Lehman research, “It is not unusual to have a variable cost of moving an incremental barrel in the range of a nickel, while you collect a dollar from the shipper.” Further, the pipeline business tends to be fee-based, with fees set by Federal Energy Regulatory Commission (FERC) on the basis of volumes — an arrangement that separates pipeline operating margin from commodity prices. A stronger economy further strengthens the pipeline case, since an improving GDP implies greater demand and volume in crude oil and refined products, which are largely moved by pipeline.
True, taxation might be an issue for some. MLP investors receive no 1099s and instead get end-of-year K-1 forms, which state the amount of capital returned that must be recognized as passive income on Schedule E. The unfamiliar K-1 form places a heavier accounting burden on the self-filer, though hefty MLP returns may (generally) make the effort worthwhile.
David Kogan, a Pennsylvania-based stockbroker who manages accounts for many retirees and recommends MLPs, notes that 90 percent of his clients hold MLPs in their non-retirement accounts, and claims the tax consequences are not at all baleful.
Two That Clear the Bar
There are currently two MLPs worthy of recommendation: Magellan Midstream Partners (NYSE: MMP) and Valero LP (NYSE: VLI). Both have proven records of distribution growth and a history of conservative asset management. Further, both MMP and VLI added new pipelines during 2002-2003, assets that will likely generate future unit-distribution growth for limited partners.
The revenue stream at both pipelines is supported by solid fundamentals. Volume growth in gasoline — the distillate that comprises 60 percent of pipeline volume at Magellan and 65 percent at Valero — enjoys secular growth of 2 percent per year. Current winter futures prices in distillates and crude are backward-dated (meaning current prices exceed the futures), which is good news for the pipelines, says Easterbrook — though not, he cautions, for their storage assets.
Magellan's 6,700-mile pipeline traverses 11 Midwestern states and ranks fifth among U.S. pipelines in barrel-miles shipped. Its product terminals afford strategic access to the Houston Ship Channel and New York Harbor, and the partnership also owns an ammonia pipeline that originates in Texas and Oklahoma and extends into the Midwest. As with Valero, Magellan's coverage ratio, an estimated 1.5 times, is excellent and Easterbrook, who rates the company's shares “outperform,” expects “distribution growth from existing assets.”
Valero owns and operates over 4,200 miles of crude oil and refined product pipelines, primarily in the Southwest. Valero management holds a high percentage of current assets in cash — 46 percent compared to the MLP group average of 21 percent — which gives the partnership the potential to increase distribution simply by lowering its coverage ratio of 1.3 times (from the 1.0 average.) The partnership is tightly linked to Valero, the nation's largest independent refiner, as its pipelines supply Valero's refineries with crude and transport Valero's product into key markets. Even though the partnership is between 60 and 70 percent exposed to Valero, Easterbrook, who rates the shares “outperform,” says, “even when refining margins are pathetic, the pipeline volumes are fairly stable, since the terminals are close to major markets.”
MLPs may seem exotic to some, but as you can see, they are actually a rather conservative play for investors looking for some steady income and perhaps a bit of diversification.
