A. Please see our MLP 101 below (to supplement our High Yield products 101).
What is MLP?
An MLP is a publicly traded partnership that receives special treatment under the U.S. tax code.
Conditions to Meet
MLPs do not pay corporate income taxes if 90% or more of gross income is “derived from the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil, or similar products), or the marketing of any mineral or natural resource (including fertilizer, geothermal energy, and timber).” As a result, the vast majority of MLPs are related to energy and natural resources.
Who Owns a MLP?
Ownership of an MLP consists of the general partner and limited partners.
- The general partner manages the partnership and typically has unlimited legal liability.
- Investors are limited partners who provide capital and receive cash “distributions” from the partnership. Investors' ownership is in the form of common “units” which trade publicly on stock exchanges.
Why Invest in MLPs
Below are three main reasons to invest in MLPs:
a. High growth potentials
Recent shale discoveries provide growth opportunities for MLPs. Based on a March 2014 ICF International report about the future North American energy infrastructure needs and capital spending, infrastructure expenditures will total $640.9 billion between 2014 and 2035. MLPs may account for a significant portion of the spending, which may bode well for long-term growth.
b. High returns
MLPs provide competitive total returns through a combination of current yield and growth in distributions.
The best known benchmark for MLPs, the Alerian MLP Index (AMZ) has returned 15.6% annually since 2006. Since 2001, distribution growth for MLPs has averaged 7.8%, which has been 3.4 times higher than the average rate of inflation (2.3%) as measured by the Consumer Price Index (CPI).
MLPs so far have outperformed the S&P 500 and other yield-based investments on a total return basis since June 2006 and have generated some of the highest risk-adjusted returns among other energy sectors.
c. Low correlations with other assets
In addition to their return rate, MLPs are also important in constructing a balanced portfolio since they are typically not highly correlated to other asset classes.
The MLPs Today
Historically, companies with predictable fee-based cash-flow streams (such as pipelines) have been the norm in the MLP space. However, over the past several years, a number of MLPs have come to market that have direct exposure to commodity prices including oil, natural gas, natural gas liquids (“NGLs”) and coal.
As of Dec. 31 2013, there were approximately 100 publicly traded energy MLPs with a total market cap approaching $450 billion. Generally, MLPs fall in the small- to mid-cap category.
In general, MLPs can be categorized into 10 different “subsectors” based on the type of assets owned and products transported: diversified; natural gas pipelines & storage; liquids pipelines & storage; gathering & processing; propane; exploration & production; shipping; coal; refining & marketing; and oil service and other specialty.
Investor Concerns and MLP Solutions
Individual investors are largely concerned about two aspects of a MLP:
a. The administrative burden of receiving a Schedule K-1
b. Potential Unrelated Business Tax Income (UBTI)
In recent years, though, several structures have been created that attempt to address these concerns including closed-end funds, open-end funds, exchange traded funds and exchange traded notes, each of which has potential drawbacks:
CEFs provide investors with a 1099 instead of a K-1 and do not generate UBTI. Distributions are typically treated as a mix of return of capital, qualified dividends and capital gains for income tax purposes. However, many CEFs are structured as C-Corporations which can be a headwind to net asset value growth since the funds must accrue a tax liability at corporate tax rates.
OEFs also provide a 1099 and avoid UBTI. However, many open-end funds currently on the market are also structured as C-Corporations and must accrue a tax liability.
Exchange Traded Funds
ETFs passive vehicles typically based on an MLP index, provide a 1099, avoid UBTI, and trade freely on a stock exchange. However, the current ETFs are structured as C-Corporations and have the same inherent tax liabilities as closed-end and open-end funds.
Exchange Traded Notes
ETNs are similar to ETFs, but strictly speaking, ETN investors are exposed to the full faith and credit of the institution that issues the note. In addition, since they are structured as notes, distributions from ETNs are considered interest income (not dividend income). Further, fees for some ETNs are similar to actively managed strategies.
MLPs have both macro and micro risks.
Macro risks that affect the entire MLP space -
- If the economy experiences another round of weakness, MLP returns may be impacted.
- A rapid, dramatic move upward in Treasury yields may create some near-term pressure on MLPs
- An escalation of debt issues in either the U.S. or globally could negatively impact MLP valuations.
- A significant and prolonged decline in oil prices may also have a negative effect.
Any MLP also comes with its own set of risks, which generally include (but are not limited to)
- Commodity price movements
- Declines in throughput volumes
- Integration and execution risks associated with acquisitions
- Damages from natural disasters or terrorism
- Interest rate risk (as higher rates may impact distributable cash flow
The Bottom Line
MLPs can be a significant contributor to a highly diversified portfolio, but they are not for everyone and should not be considered without understanding the significant risks in addition to the potential rewards.