MLPs and royalty trusts are little-known options for current income.

For several years many advisors have been searching for higher-yielding investments, and some have turned to master limited partnerships (MLPs) and royalty trusts for that very reason.

Many of these investments are offering annual yields of 8%, 9% and even 15%. Considering that numerous market observers are predicting single-digit returns for traditional equities for several years to come, the distributions flowing from MLPs and royalty trusts look enticing, to say the least. Also, interest in investments that offer current income is expected to grow as more baby boomers reach retirement age.

But are MLPs or royalty trusts right for your clients? Maybe for some of them. The investments have similarities, but also major differences.

Like fixed-income investments, MLPs and royalty trusts trade based on their current yield. Although they may offer a steady income stream, their distributions and unit prices can fluctuate.

Both are publicly traded and owned primarily by individual investors. Most mutual funds stay away from them because the U.S. tax code limits the amount of income that they can get from such sources. Some investors shy away because their structure is more complex than that of corporate stock. And some people may hesitate to invest because they remember the highly publicized partnership losses in the 1980s.

"Partnerships got a bad rap in the '80s and deservedly so for some of them," says Mary Lyman, general counsel for the Coalition of Publicly Traded Partnerships, an MLP trade group. "The problems were not so much with publicly traded partnerships but with the tax-shelter ones designed to throw off losses. They didn't have a lot of economic substance, and the IRS cracked down on them pretty heavily. A lot of investors in the tax-shelter partnerships had a lot of losses they couldn't deduct. There were a lot of oil and gas and real estate partnerships that didn't do too well." With the ones that weren't publicly traded, investors had a hard time getting out, she adds.

Today, royalty trusts and the majority of MLPs get their cash flow from businesses in the energy industry. Both can be structured to pass through their available cash flow to investors and avoid the double taxation imposed on corporate dividends. Distributions are a combination of net income and what is basically a return of capital. The return of capital, actually an allowance for depletion or depreciation, decreases an investor's basis, and taxes are deferred on that portion of the distribution until the units are sold. As a result, tax filings for both are more complicated than they are for corporate stock.

One difference between the two investments is that cash flowing into royalty trusts primarily comes from oil and gas exploration, while cash going into energy-related MLPs usually comes from energy processing and distribution.

In most cases, royalty trusts aren't partnerships and all units are equal. Not so with MLPs, which have a general partner that operates the partnership, usually has about a 2% general partnership interest and owns common limited partnership units as well. As an MLP increases its distributions to common unitholders, the general partner usually gets a disproportionately higher amount of total distributions as an incentive. Some observers think these incentives are appropriate; others do not.

Since they trade based on their current yield, rising interest rates can negatively affect MLPs and royalty trusts. However, they generally have more impact on the unit prices of MLPs, whose fees, based on contracts, won't necessarily be rising at the same time. Royalty trust units often are less affected because inflation generally accompanies interest-rate hikes, and that means the prices they get for their oil and gas will rise, too.

One reason some analysts and portfolio managers like energy MLPs is because their cash flow comes from fee-based businesses, such as the delivery of oil and natural gas through pipelines. Because they are delivering products rather than exploring for them, their distributions tend to be more stable than those of royalty trusts and aren't affected much by fluctuations in energy prices. A short reserve life of the oil and gas fields that generate cash for a royalty trust often means distributions won't last very long. On the other hand, at least one well-known energy analyst thinks royalty trusts and other energy investments are better bets than MLPs, many of which he believes are poised for problems because of high debt and payments to general partners.

Gerald Kaminsky, managing director of The Kaminsky Group at Neuberger Berman LLC, has achieved strong results investing in MLPs. "The safety of the businesses that comprise a given MLP is the critical criteria for us making an investment," Kaminsky says. "There are many businesses in the MLP mold. Each of these has different risk characteristics. We have looked at MLPs and invested where the client objectives are capital safety, high current income and preferably tax advantaged. We've incorporated both the MLPs and the management companies of some in different pools of assets where appropriate."

He thinks the fundamentals of many MLPs make them attractive. "Pipelines are long-lived assets, without significant technological risk of obsolescence. As you look at the annual reports and financial reports, it's clear they generate a lot of cash. Some have been able to grow organically and by acquisition. There are many reasons organic growth will continue based on the underlying demand for energy in this country and based on the economies of scale as you put more products or revenues through a fixed-cost type of business."

Kaminsky adds his firm has considered royalty trusts, but has not invested in them, primarily because their distributions aren't as stable as those of MLPs. Distributions of royalty trusts can rise and fall with oil and gas production and prices, he notes. "There's more volatility. They have commodity risks that MLPs profess not to have or mitigate," he says.

Some of Neuberger Berman's significant MLP holdings include Enbridge Energy Partners, GulfTerra Energy Partners, Kinder Morgan Energy Partners and TEPPCO Partners.

AG Edwards Senior MLP analyst Ron Londe follows oil and gas pipeline MLPs, as well as those involved in propane and coal.

"Basically the MLPs are just like corporates [corporate bonds], and we analyze them just like corporates, but they are taxed like partnerships and their reason for being is to generate as much cash flow to the unitholder as they can. So we key in on distributable cash flow, and look at the competitive situation in the group they're in, the coverage for the distribution and the balance sheet numbers. We look at the growth potential from acquisitions and expansions and their businesses. We look at their valuation relative to their peer group. We look at the ten-year Treasury note rate and the premium MLPs are offering. The premium over the long term is 300 basis points. We also try to gauge coverage distribution relative to their peer group," Londe says.

He adds an MLP investor should diversify his or her holdings. In the oil and natural gas sector, he likes Plains All American Pipeline, TEPPCO and MarkWest. "Here again they have good records of growing distributions and good coverage. They have balance sheets that are strong and the flexibility to make acquisitions," he says.

The MLPs in the propane business he likes are Inergy and Heritage Propane Partners. In coal, he likes Alliance Resource Partners and Penn Virginia Resource Partners.

Widely respected independent energy analyst Kurt H. Wulff takes a dimmer view of many MLPs. "Their basic business is more stable and they're not as affected by swings in commodity prices, but that stability is partly offset by greater leverage and further by the free ride the general partners gets. So when you put all together, they are not a particularly safe investment," he comments.

Wulff says many MLPs are now overvalued and are paying distributions in excess of their sustainable capacity.

Most general partners are getting 50% of incremental cash flow from their properties, he says. "They are diluting ownership because they are buying properties that offer a competitive economic value at eight times cash flow, and it will pay enough of a return to get the principal back and make 6% to 8%. The limited partners are responsible for the debt. The general partner is taking an equal amount but puts up no money. In the end, the properties aren't good enough to pay both," Wulff maintains. He adds general partnership interests often are not fully reported.

Of the MLPs he covers, he doesn't recommend buying any of them and in fact recommends selling Kinder Morgan, Enbridge and GulfTerra, in part because of concerns about their payouts. A July 30 rupture in a 48-year-old pipeline between Tucson and Phoenix owned by Kinder Morgan spewed up to 10,000 gallons of gasoline on five houses under construction, and the accident might not have happened if the partnership took less money for itself and spent more on protecting the public, Wulff maintains.

However, Kinder Morgan, which owns more than 25,000 miles of pipelines that transport 2 million barrels of gasoline and other petroleum products per day, says it is highly concerned about public safety. In a prepared release, Tom Bannigan, president of KMP's products pipelines, comments, "Our priorities have been, and continue to be, to operate our pipelines safely and to provide adequate fuel supplies to our Arizona customers."

Although he thinks many MLPs should be avoided, Wulff says one oil and gas MLP, Dorchester Minerals, may be worth a look. Although he believes it has a high valuation and hasn't recommended buying it, Wulff says his analysis may not be fully recognizing Dorchester's low risk-it has no debt and owns royalty interests in some properties. It also isn't paying out any high general partnership compensation, he adds. He notes Enterprise Products Partners recently cut its GP compensation to 25%, but other MLPs have yet to follow suit.

Wulff believes royalty trusts and traditional energy stocks are better investments than MLPs. A key tool he uses to evaluate energy investments is a measure he developed, the McDep ratio, which is an entity's market cap plus debt divided by the present value of oil, gas and other businesses. More information on his analysis is available at www.mcdep.com.

Royalty trusts, some of which are based in the United States and others in Canada, also must be evaluated carefully, he says. A fundamental question is how long is the life of a royalty trust's reserves, which generate the cash flow paid to investors, he says. Also, it's important to understand where the interests lie of the company that sponsors a royalty trust, Wulff adds.

Royalty trusts he currently recommends are Canadian Oil Sands Trust, which produces oil from Canada's Alberta Oil Sands, and San Juan Basin Royalty Trust, which owns natural gas and oil fields in New Mexico's San Juan Basin.

Another fan of San Juan Basin is Jean-Marie Eveillard, manager of First Eagle Global Fund, which now owns more than $15 million worth of units and has had a position in the trust for 20 years. "We've looked at others in the past, but none of them from our own point of view was better than San Juan Basin," he says.