Chuck Moore, a retired college professor and real-estate investor in Nevada, said he started buying into oil and gas pipeline partnerships last year after fleeing stocks and searching for yield.
Master limited partnerships, as the securities are known, typically are organized around energy and natural resources. They invest in assets ranging from pipelines to ships transporting commodities and are traded on exchanges such as the New York Stock Exchange or Nasdaq. Kinder Morgan Energy Partners LP, is yielding 6.21 percent, and its unit price, similar to a share price, has jumped 13 percent this year.
Investors are pouring into energy-related MLPs, increasing their market capitalization 20 percent as of July to $183 billion from $152 billion in 2009, said Michael Blum, a managing director at Wells Fargo Securities, a unit of San-Francisco- based Wells Fargo & Co. About 90 percent of new equity in the partnerships last year came from retail investors, he said.
The yields, quarterly distributions, which are similar to stock dividends, and tax-deferrals on most of the income received make them attractive to wealthy investors.
“I see them spreading across people’s tax returns like wildfire,” said Bill Fleming, a managing director in the Hartford, Connecticut, office of PricewaterhouseCoopers LLP, the New York-based accounting and advisory firm.
The yield on the Alerian MLP Index, composed of 50 of the about 90 publicly traded partnerships, is about 6 percent. That compares with about 2 percent for the dividend yield on the Standard & Poor’s 500 Index, according to data compiled by Bloomberg. The average yield on an investment-grade corporate bond was 4 percent as of Aug. 4, while 10-year Treasury notes were yielding about 2.95 percent.
Pamela Rosenau, a managing director at HighTower, a Chicago-based advisory firm, builds $1 million or larger MLP portfolios for clients, choosing investment-grade partnerships in energy pipelines that function like toll roads, she said. The partnerships rely on assets that generate steady cash flow used to make payouts to unit holders. El Paso Pipeline Partners LP, for example, collects revenue from long-term contracts for transporting natural gas.
“We’re in a very low interest-rate environment and a very uncertain economic environment,” said Rosenau. “The average current yield of the partnerships I own for my clients is between 6 and 7 percent.”
“It’s a huge tax advantage,” said Rosenau, “Eighty-five to 90 percent of my distributions are tax-deferred. I have the use of that money for years and years.”
Risks of investing in MLPs include a lack of liquidity because a few trade below 100,000 units a day, said Mark Easterbrook, a Dallas-based analyst with RBC Capital Markets Corp., who covers the group. Another is share volatility, especially partnerships whose income relies on commodity prices rather than fee-based contracts for transporting them. Several MLPs reduced or suspended their distributions in 2008 and 2009 because they couldn’t raise enough money to pay investors, Easterbrook said.
Investors should look for MLPs with increasing payouts and access to capital, said James Shelton, chief investment officer at Houston-based Kanaly Trust, which manages $1.6 billion. Shelton’s firm has invested in Kinder Morgan Energy Partners LP, which moves and stores energy such as jet fuel, and Enterprise Products Partners LP, which transports natural-gas liquids and other products. The companies are the two biggest U.S. pipeline partnerships by market value.
Rising interest rates are another concern, said Ronald Barone, a managing director at UBS Securities LLC, a division of UBS AG. Higher rates on securities such as government bonds will make MLPs less attractive unless they can offer even higher yields, said Barone, who’s based in Dallas and covers the partnerships.
More than three-quarters of MLPs trading in the U.S. are energy-related because the tax code limits the type of income they can earn mainly to natural resources businesses, said Mary Lyman, executive director of the National Association of Publicly Traded Partnerships, a Washington-based trade group representing the industry.
Typically 75 percent to 80 percent of the cash distributions are tax-deferred until units of the MLP are sold, which is appealing to high-income earners worried about taxes, said Lyman. In 2011, federal income tax rates are expected to rise to as high as 39.6 percent from 35 percent, unless Congress acts.
Moore, the investor, said he worries the government might take away the tax advantages of MLPs to raise revenue.
“The real big caveat and the reason I’ve lightened up is the federal government is broke,” said Moore, who had invested about $2 million.
Investors receive a K-1 tax form each year and must declare their MLP earnings and deductions, said Fleming of PWC, whose average client has investable assets of $4 million to $20 million. That may increase tax-preparation costs by several hundred dollars or more because of the added work involved, Fleming said. “They can be a mess,” he said.
Investors may have to pay ordinary income and capital gains rates on the non-deferred portion of their MLP investments and they may be subject to levies in multiple states in which the partnership operates or does business, said Tim Fenn, partner in the New York office of Latham & Watkins LLP. Since earnings are considered business income, not investment income, individuals who use them in tax-deferred Individual Retirement Accounts may owe taxes, Fenn said.
There are three open-end MLP mutual funds, including SteelPath MLP Income Fund, which started in May, according to the industry trade group. Legg Mason Inc.’s ClearBridge Advisors unit completed a $1.27 billion initial public offering in June for a closed-end fund that invests in energy-related MLPs. JPMorgan Chase & Co. listed an exchange-traded note in April tracking the partnerships, which had $1.26 billion outstanding, and UBS began trading an ETN in July. ETNs are unsecured bank debt whose value is designed to mirror the performance of an index.
“As long as people keep using electricity and driving their cars and heating their homes, there is going to be a need for gas and oil pipelines,” said Moore, the investor.