It's time to answer the “who, what, when, where, and why” of investing in master limited partnerships (MLPs)…

Andrey Dashkov, our senior research analyst, is the rare person who, when you asked for a hammer comes back with a hammer, nails, staples, and glue. In short, he often comes up with better solutions to tricky problems than I ever thought possible.

Since Andrey and I are on a nonstop mission to unearth the best opportunities for generating safe income, we have looked to MLPs more than once (see the October 2013 edition of Money Forever). Many Business Development Companies (BDCs) and Real Estate Investment Trusts (REITs) also fit the bill. Today, however, we are focusing exclusively on how MLPs can produce a healthy and steady income without exposing your nest egg to unwelcome risks.

The Nuts and Bolts of MLPs

By Andrey Dashkov

An MLP is an entity structured as a limited partnership instead of the traditional C-corporation. This allows the company to avoid corporate-level taxes. The limited partners pay most of the taxes, which means that MLPs are essentially pass-through entities.

In the United States, the net effective rate of corporate income tax is 40%. That means a corporation calculates its profit, pays the appropriate income tax to the government, and then pays dividends from what remains. With an MLP all the profits are passed through to the unit holders.

While a traditional corporation can choose to pay a dividend, an MLP does not have that option. In order to maintain their status, MLPs are required to generate at least 90% of their income from qualifying sources and distribute the major portion of that income. In most cases these sources include activities related to the production, processing, and distribution of energy commodities, including gas, oil, and coal.

The government gives a special treatment to these activities to encourage investment into the United States' energy infrastructure.

Limited partners (LPs) own the company together with a general partner (GP). The GP takes care of the day-to-day operations, typically holds a 2% stake, and can usually receive incentive distribution rights (IDRs). LPs, called unit holders, (which we can become by buying shares of publicly traded MLPs) receive dividend-like cash distributions. LPs, unlike traditional shareholders, do not have voting rights.

There are many advantages to MLPs, including:

  • Attractive yields;
  • Inflation protection;
  • Portfolio diversification;
  • Tax advantages; and
  • Resilient business model.

Attractive Yields

MLPs pay various yields that average 5-10%. Data for the Alerian Index, which tracks the top 50 MLPs, show that in Q2 2013 MLP yields varied from 3-12%, with an average of 6.5%. Besides the actual yield, MLP investors can count on distribution growth. Dividends per share of Alerian Index constituents grew at a compounded rate of 4.1% over the past five years.

Inflation Protection

Several factors hedge against inflation:

  • Inflation-adjusted contracts renewed periodically;
  • Distribution growth has historically outpaced the growth in CPI; and
  • MLP unit (share) prices are weakly correlated with movements in inflation and interest rates.

Portfolio Diversification

MLPs have a low correlation to other asset classes, including equity, debt, and commodities. However, for a short time they may correlate with any asset class or the market in general.

MLPs are less volatile than the broad market. Currently at 0.5, the average beta of Alerian Index, is quite conservative. This suggests that if the broad market goes down by 10%, we should expect the Alerian Index to drop by 5%. An individual company's volatility may stray from the average, but in general MLPs should be much less volatile than the market as a whole.

Generally, the vast majority of MLPs operate in the energy sector, but usually do not own the underlying commodities; this is part of the reason for the decreased volatility. Their income generally consists of transportation fees. However, some MLPs can be exposed to commodity risk (coal, propane, and oil exploration and production MLPs, among others). Economy-wide consequences of a severe recession may impact the demand for energy commodities and, in turn, the profitability of transportation companies.

Tax Advantages

An MLP investor typically receives a tax shield of 80-90% of one's annual cash distributions, which is a very nice feature. This defers tax payments until the unit (your share) is sold.

The tax payment schedule for an MLP is illustrated below. Assume you bought one unit of an MLP for $20 and sold it after five years for $22, having received $2 annually in years 1-5. Assuming your ordinary income tax is 35%, and the long-term (LT) capital gains are taxed at 15%, you can see the breakdown.

  Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Purchase price $20.00          
Distribution per unit   $2.00 $2.00 $2.00 $2.00 $2.00
Income per unit   $2.00 $2.00 $2.00 $2.00 $2.00
Depeciation expense   $1.60 $1.60 $1.60 $1.60 $1.60
Cost basis $20.00 $18.40 $16.80 $15.20 $13.60 $12.00
Sale price           $22.00
Earnings per unit
  $0.40 $0.40 $0.40 $0.40 $0.40
Depreciation recapture
Amount subject to ordinary tax rates   $0.40 $0.40 $0.40 $0.40 $8.40
Ordinary tax rates
  35% 35% 35% 35% 35%
Taxes owed at ordinary rates   0.14 0.14 0.14 0.14 2.94
Amount subject to LT capital gains           $2.00
LT capital gains rate
Taxes owed at ordinary rates           $0.30
Total taxes owed   $0.14 $0.14 $0.14 $0.14 $3.24
Source: Credit Suisse

Resilient Business Model

During periods of economic uncertainty, MLPs remain a solid source of income. In 2008-2009, 78% of all energy MLPs either maintained or increased their distributions. In comparison, 85% of real estate investment trusts (REITs) either cut or suspended dividend payments.

Now, a note of caution is in order. Despite the excellent income track record, MLP share prices stumbled as they became more correlated to the general market. However, the investors who held them through the difficult times saw the share price rise again. MLPs returned to January 2008 levels in early 2010; the S&P 500 did not do the same until 2013.

The same plunge could happen again if a severe economic crisis hits. As we said, MLPs may move with a falling market. The fact that more investors are aware of MLPs now than a decade or two ago adds to this risk. As investors have searched for yield, MLPs have become more mainstream; however, they are by no means your average S&P 500 stock.

Also, there are two immediately positive outcomes to the higher investor awareness of MLPs: higher liquidity and access to more capital. In the Money Forever portfolio we look for the best and safest available and then protect our downside with protective stop losses.

Principal Risk Areas

With any investment offering a reward, there is a corresponding risk. Here are the key risks of MLPs.

Risk #1: Economic downturns. If the US economy is hit by a severe economic crisis that drives the demand for energy products down, MLPs will take a blow. Like a trucking business that transports products for which the demand is going down, if less product is shipped through a pipeline owned by an MLP, their revenue may decrease.

This, however, is where some investors may get confused. If a pipeline MLP has a contract with an energy company, the price of the transported product may increase or decrease, but at the same time, the MLP may have a fixed-fee arrangement with the energy company. So, if the volume flowing through the pipeline remains steady, its revenue should not fluctuate.

Risk #2: Access to capital and interest rates. As a general rule, MLPs return 100% of their distributable cash flow (DCF), less a reserve determined by the general partner, to the unit holders. Unlike real estate investment trusts that must give away a certain share of their cash flow every quarter, MLP distributions are governed by individual partnership agreements, so the terms vary.

However, the majority of cash an MLP earns will be distributed, so it's only natural that they turn to issuing debt or equity to finance growth projects. When their interest costs rise MLPs that need capital right away will be at a disadvantage. We prefer companies with enough internally generated capital to finance growth, and no major ongoing projects that require billion-dollar loans and thereby run the risk of being underfunded or funded at an unfavorable interest rate. We also prefer companies with fixed-rate debt to floating rate.

Risk #3: Management and execution. Management should have a track record of successful investment in new assets and cash generation to finance distributions.

We also look for companies that have 5- to 10-year capital plans as part of the write-up, and a history of following those plans. They tend to fare better when it comes to keeping capital costs under control.

Risk #4: Sustainability of cash distributions. The above three risks boil down to whether or not an MLP will be able to churn out cash for its unit holders. The distributions should be sustainable, and should grow year after year. The primary reason for buying an MLP is income. We need to make sure the cash keeps coming in.

A company's track record of cash payments is a good, but not perfect, indicator of how it will perform in the future. Variable-rate distributions tend to, well, vary more significantly than those of traditional MLPs. Distributions in the midstream sector tend to be more predictable; natural gas pipelines and storage generate the most stable cash flows while refining/upstream MLPs do so to a lesser extent. We carefully consider these factors when evaluating our investment options.

The “Taper” Factor

When Ben Bernanke uttered the word “taper” on June 19, the markets jittered. Even the traditionally defensive sectors such as utilities took a hit.

MLPs were not immune to the potential implications of the Fed easing up on its bond-purchase program which many believe is helping the US economy. The market panicked, and MLPs dropped in price. Readers will note the index dropped in the middle of 2013. The drop was less steep than those in either the broad market or the utilities sector and MLPs rebounded—in less than a week, while it took approximately three weeks for both the S&P 500 and XLU to get back to their June 18 levels.

When evaluating a potential candidate, a prudent investor will see how they have performed during times of market volatility. Sometimes trading a bit of yield for much less volatility is a smart move.

The IRA Caveat

We do not recommend putting MLPs in an IRA account. By placing an MLP in a tax-deferred account, you may lose part of the tax advantage the MLP structure provides. In an IRA account, unrelated business taxable income (UBTI) of over $1,000 is subject to federal income tax. If you earn more than $1,000 annually from an MLP's cash distributions and other sources of UBTI, the excess will be taxable. This becomes more likely over time, since most MLPs increase their cash distributions.

A Peek Behind the Curtain

In summary, an MLP gives us a couple of advantages from a tax perspective. There is more money to pay out in dividends. Unlike a traditional corporate dividend, which is paid after a corporation pays income taxes, MLPs do not pay corporate income taxes. An MLP's income is taxed only once, when the dividends are received.

Initially, when you buy an MLP, only 10 to 20 percent of the MLP distribution is considered taxable income. The rest of the distribution is considered return of capital and isn't subject to tax when you receive the dividend. Basically you put off paying some taxes for the short term. When you eventually sell your MLP, the tax is adjusted so the net amount of taxes is the same. The formula is technical, but the information you receive from your broker can be given to a competent CPA and you should be fine.

You can see why MLPs have become so popular in a yield-starved environment. While they have attracted a lot of investors, there are still some great opportunities for those willing to do their homework.

Dennis and I added our favorite MLP to the Money Forever portfolio in October, and we are chomping at the bit to share it with you… But, because of the special relationship we share with our paid subscribers, you'll need to either sign in to your Money Forever account or sign up to for a premium subscription at no-risk to your pocketbook to find out what it is. Subscribe to our regular monthly newsletter and take a peek at the MLP we recommended, along with our entire portfolio. If, after 90 days, you decide it's not right for you, we'll return 100% of your money without a fuss. Click here to get started.

On the Lighter Side

Folks, it's Dennis here again. American football fans had quite a weekend as the NFL play-offs began. Three of the four games went right down to the wire. Then on Monday night the college football season ended with a very exciting comeback by Florida State to win the national championship. If you are a football fan, it was certainly exciting.

And finally…

I am blessed to have family, friends, and readers who take the time to send clever tidbits for my closing remarks. It is amazing how often the material is not only clever or funny, but also personally very timely.

Having received a stern lecture from my doctor about the need for diet and exercise, I have been dutifully dragging myself onto the treadmill with some regularity. This morning it was particularly challenging. I had a lot to do and a dozen excuses lined up in my head. Ultimately, logic took over, and I got on the treadmill before I could talk myself out of it.

After I was finished, I opened up my email and our dear friend Toots had sent me some tips about seniors and exercise. Here are some snippets:

  • A whale swims all day, mainly eats fish, drinks water, but is still fat.
  • A rabbit runs and hops, but only lives 15 years.
  • A tortoise doesn't run and does mostly nothing, yet it lives for 150 years.

And I should exercise?

It was probably a good thing I walked before I opened up my email today.

Until next week…