Oil and gas are classic boom-and-bust industries, and last year, they played to form: In midsummer of 2008, the prices in this space were setting gravity-defying records. By year's end, however, gravity finally brought them plunging down, and they remained depressed through early 2009.
The dividend world, on the other hand, had generally been a steady-as-she goes place until the recent financial crisis created a bust cycle where seemingly impregnable dividend payouts from the likes of financials, automakers and other corporate stalwarts have vanished or been slashed.
So where are income investors to go for fat yields now? Perhaps it's in that same tempestuous oil and gas patch. Specifically, it may be found in high-yielding royalty trusts and master limited partnerships (MLPs).
These publicly traded vehicles are predominately tied to natural resources (particularly in oil and gas), and they pay tax-advantaged and often sizable distributions to investors. The recent yields from these investments were in the 8% to 15% range, more or less.
In the U.S., royalty trusts are passively managed entities overseen by banks. They don't actually dig or drill. Instead, they own the mineral rights to mines and wells, and they depend on others to extract the resources from the ground. By law, they must pay out 90% of their cash flows and provide depletion deductions to investors (who own units, not shares, and are called "unit-holders.") The distributions are taxed as income, but the return of capital portion is actually an allowance for depletion and depreciation that decreases an investor's cost basis. And taxes on that portion of the distribution are tax-deferred until the units are sold.
MLPs, meanwhile, are structured as partnerships, meaning they avoid corporate income taxes. Instead, they pay taxes only on the distributions. Investors buy units and become limited partners who receive quarterly distributions that typically amount to 90% of the MLP's generated income as required by tax law. Distributions are taxed as ordinary income.
Generally, MLPs get their money from transporting and processing natural resources, while royalty trusts collect cash from extracting resources from the ground. (There are some MLPs tied to exploration and production, too, a category known as E&P MLPs.)
Plugging a Hole
Some advisors believe these investments can be a good income play in the current environment. Troy Smith, a certified financial planner in Raleigh, N.C., uses MLPs for some of his clients as an "income repair" tool to make up for market declines that have eaten into the principal of his clients' portfolios.
"If you're taking a 4% distribution from a portfolio and 3½% came from a yield and the rest from principal, it's easy to move that part of the portfolio to something with a fatter yield," Smith says. So that his clients can reduce their reliance on principal for retirement cash flow, Smith uses MLPs along with preferred stocks and funds, high-yield funds, closed-end funds and the like.
"A lot of investors are waiting around for the market recovery, and it's a silly strategy to sit there and hope for upside," Smith says. "Here, you can get compensated for waiting. That reduces your overall risk."