Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

Despite some recent and minor market rebounds, oil and the broader energy sector remain down-and-out. Contrarian-minded investors are no doubt preparing to pounce, and some may have their eyes on Master Limited Partnerships (MLPs) -- publicly-traded partnerships that largely own energy infrastructure in the U.S.

But investors who view MLPs as a proxy for energy are making a big mistake (and as my Gadfly colleague Liam Denning has already noted, investors who also used to think of certain MLPs as reliable, utility-like havens have "realized their mistake").

The recent movements of oil and MLPs, for example, are instructive. The price of oil tumbled 55 percent from July 2014 to August 2015, but the Alerian MLP Index declined just 37 percent over the same period.

No Bargain
The Alerian MLP Index isn't as cheap today as energy's woes would imply.
SOURCE: Bloomberg
SD stands for standard deviation. The Alerian MLP Index's historical average yield and SD implies that 95 percent of the time the yield can be expected to be between 4.7 percent and 10.3 percent.

The fact that MLPs were spared the worst of oil’s drubbing during that period was the difference between a bona fide buying opportunity and, well, not so much. The average yield of the Index has been 7.5 percent since inception in 1995, with a standard deviation of 1.4 percent. Following the Index’s decline of 37 percent, its yield was an unremarkable 7.7 percent. But had the Index suffered oil’s decline of 55 percent, its yield would have spiked to 10.8 percent -- a legitimate bargain by any measure (and a 2+ standard deviation event coveted by value investors).

MLPs have also eclipsed oil on the way up, and this too has made all the difference. Oil has rallied 19 percent over the last three weeks, while the Index has gained 32 percent over the same period. The Index’s yield is currently a ho-hum 8.9 percent, but had it been only as fortunate as oil, its yield would be a far sexier 9.9 percent (and very nearly a 2 standard deviation event). 

Poor Proxy
MLPs have escaped the worst of the carnage visited on oil.
SOURCE: Bloomberg

MLPs are undoubtedly an energy play, so why have MLPs not danced to energy’s rhythm?

Well, it turns out that there are two entirely different classes of MLP. One is deeply distressed and amply reflects all of the energy sector’s woes. The other -- are you ready for this -- actually is a safe haven.

Not surprisingly, safe-haven MLPs have held up remarkably well, while distressed MLPs are in the toilet. You can see this very clearly by dividing the Alerian MLP Index into halves of lowest yielding MLPs (safe haven) and highest yielding MLPs (distressed).

The safe-haven MLPs are priced like a Burgundy Grand Cru, with an accompanying weighted-average yield of just 6.3 percent. The distressed MLPs are priced like toxic subprime mortgages, with an eye-popping yield of 18.1 percent. (The safe-haven MLPs represent nearly 75 percent of the Index by weighting.)

But are safe-haven MLPs actually higher quality than their distressed counterparts, or are investors behaving irrationally? To find out, I looked at commonly used measures of quality for MLPs -- leverage, distribution coverage ratio (the amount of cash available for distributions to limited partners divided by actual distributions), and distribution growth.

I gathered the Bloomberg data for every publicly traded MLP in the U.S. for which all three measures of quality are available -- a sample size of 58 MLPs. I then divided these 58 MLPs into halves of lowest and highest yielding MLPs, as I did with the Alerian MLP Index, and the spread was similarly large. The lowest yielding MLPs have a weighted-average yield of 7.2 percent, while the highest yielding MLPs have a yield of 22 percent.

And for You?
MLPs today are either a distressed play or a quality play.
SOURCE: Bloomberg
Yield and distribution growth expressed as a percentage; debt-to-equity and distribution coverage ratio as a ratio.

There is a clear quality difference between the two groups of MLPs. The safe havens have lower leverage -- a weighted-average debt-to-equity ratio of 1.2 versus a ratio of 1.4 for the distressed group. The safe havens also have a greater cushion for future distributions -- a distribution coverage ratio of 1.5 versus 1.2 for the distressed group. The distributions of the safe havens grew by 44 percent last year while those of the distressed group grew by 21 percent.

So within MLPs are two entirely different investments, each expressing its own vision of energy’s future. If you believe that energy’s recovery is on the horizon, distressed MLPs are a treasure in plain sight. If you believe, on the other hand, that energy will struggle for the foreseeable future, safe-haven MLPs are the only choice.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in New York at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Timothy L. O'Brien at tobrien46@bloomberg.net