In this low-interest-rate environment, master limited partnerships look like an ideal way to boost clients’ yield and total return. 

Most of these business partnerships, typically traded on a stock exchange, are yielding 6% to 8%. They trade at a spread of more than 400 basis points over 10-year U.S. Treasury bonds and 200 basis points over utility stocks and real estate investment trusts, based on the Alerian MLP Index. And over the past year ending in January 31, the index of 50 prominent MLPs registered a 10% total return.

With master limited partnerships (MLPs), limited partners invest in a partnership run by someone else, typically a “general partner.” However, unlike an investor in stocks, limited partners generally have no voting rights. Plus, a limited partner, also known as the “unit holder,” generally pays fees to general partners out of distributions. 

MLPs are attractive because they avoid the double taxation of publicly traded corporate dividends, while passing depreciation and expenses through to investors. Some 80% of the distribution of income may be considered a return of capital. And those distributions can cushion MLP price declines in down markets. Pending bipartisan federal legislation could pass along MLP tax benefits to renewable energy companies.

MLP revenues are strong because of the global demand for oil and gas. The majority are pipeline businesses, which earn stable income from the transport of oil, gasoline or natural gas.

One MLP fund manager says master limited partnerships are in a good position to take advantage of U.S. energy infrastructure growth. Going forward, he estimates a double-digit expected rate of return.

He tends to invest in general partnership MLPs, a subset of the MLP market consisting of separately traded stocks that pay the general partner an incentive fee out of distributions for good performance. Historically, he says, these MLPs show greater income distribution than their counterparts.

Despite positive fundamentals, MLPs, he says, require selectivity. MLP prices come under pressure when the overall stock market declines or during a credit crisis like the one in 2008.

“We select companies with stable and growing cash flows, no commodity risk, strong management and the ability to expand distribution,” he says.

Those metrics put him in MLPs such as Energy Transfer Equity, Enterprise Product Partners, Intergy Partners and PVR Partners. The companies all are involved in natural gas and liquid natural gas storage, transportation and production in the United States and Canada.

Pimco, the Newport Beach, Calif., investment company, is bullish on the energy sector. The headline of the firm’s recent global credit perspective report calls energy investments a “game changer.”

John Devir, Pimco senior credit analyst, says his company favors midstream master limited partnerships because they transport oil from shale and oil sands. He says the International Energy Agency expects the United States to produce more oil than Saudi Arabia by 2017. The United States also is expected to be energy independent by 2025. Current pipeline supplies are not enough based on energy demand. So large geographically diversified master limited partnerships should profit from building pipelines to ship liquid natural gas, ethane, propane, crude oil and coal to U.S. refiners.
“Pimco believes there are several U.S. midstream energy companies that can grow two times faster than the U.S. economy with no exposure to Europe and/or China,” Devir says. “Their earnings are highly predictable and backed by guaranteed ‘take or pay’ contracts with highly rated customers.” “Take or pay” contracts require recipients of a shipment to take it or pay a penalty.

Although investor demand for high-yielding master limited partnerships is strong, advisors must consider the risk, stresses Ethan Bellamy, senior research analyst at Robert W. Baird & Co., Milwaukee, Wis. He recommends just a 5% to 15% allocation to MLPs.

“Unlike utilities, MLPs as serial capital raisers must access an open capital market to fund growth,” he says. “This can subject the investor to equity-like volatility.  MLPs rely heavily on debt financing, which has shown its mercurial shortcomings in the last several years. Also, large-scale tax reform in 2013 or beyond could jeopardize the pass-through nature of MLPs.”

Financial advisors need to scrutinize an MLP’s business plan before investing client money, says Roger Conrad, chief investment strategist of Investing Daily, the Falls Church, Va., publisher of MLP Profits. Conrad says an important variable is the location of pipeline companies that connect to processing facilities. Investors should stick with MLPs with a history of paying and growing dividends. Plus, investors need to avoid gas-processing MLPs that are sensitive to the price of oil in relation to gas as well as initial public offerings.

“MLP investments offer investors tax-advantaged high yields and strong recession-resistant growth potential—two essential ingredients to protecting wealth in such a turbulent market,” Conrad says.

Three publicly traded partnerships in his portfolio include Enterprise Products Partners, one of the country’s largest and oldest MLPs. The MLP focuses primarily on the ownership of assets related to natural gas. Linn Energy is involved in the actual production of oil and natural gas from fields located in California and the mid-United States. Eagle Rock Partners is in oil, gas and liquid natural gas production, as well as in pipelines and processing facilities.

Other analysts say advisors should not overlook integrated oil companies. Royal Dutch Shell and Chevron are engaged in gas-to-liquid production, according to Standard & Poor’s analyst Vaughn Scully. Converting gas to liquid is a lower-cost way to transport gas via pipelines.

Clients seeking diversification in pipeline companies that transport oil from shale might consider the PowerShares Dynamic Energy Sector Portfolio. This exchange-traded fund invests in both oil companies and MLPs. Vaughn favors the Energy Select SPDR Fund and the iShares S&P Global Energy Sector Index Fund, which invest in integrated oil and master limited partnerships involved in gas and oil exploration.

When it comes to safety, liquidity and yield, however, MLPs carry their share of risks—apart from potential high volatility. For example:
• Liquidity could be a problem in this thinly traded market. The 50 largest MLPs that make up the Alerian MLP Index have a total market capitalization of $306 billion. By contrast, Exxon Mobil has a capitalization of $400 billion.
• MLPs can face commodity risk when exploration, transportation and processing of energy products decline. Revenue from S&P 500 energy companies was down 15% in the third quarter of 2012 due to tepid economic growth.
• Master limited partnership correlations may rise in relation to other assets as stock prices plunge in a bear market, such as the one in 2008. In 2008, MLP stocks lost 50%.
• Environmental concerns could put a damper on fracking technology, which is used to extract gas from shale.
• As MLP limited partners, your clients could wind up footing some unexpected bills, such as the partnership’s state and local taxes.
• When interest rates rise, master limited partnership prices typically drop because of higher capital costs. 
• Distributions are not guaranteed.
• Investors may have no power to remove bad management.
• Debt-burdened partnerships could have a tough time borrowing.
• A partnership may depend on negotiated land leases for energy pipelines.
• Meanwhile, laws could change next year, wiping out tax advantages.

In addition, MLP tax filings are complex. Clients must receive K-1 statements, rather than 1099s. Large investors may have to file returns in every state in which the MLP does business. In the early years of an investment, distributions are almost always tax-free due to an MLP’s depreciation deduction. But after several years, the distributions are fully taxable.

Clients with a MLP in a retirement savings account still may owe Uncle Sam for unrelated business taxable income.
One way around this potential tax headache is to invest in master limited partnership exchange-traded notes, exchange-traded funds and closed-end funds, structured as C corporations. With these investments, clients get a 1099 and can invest in an IRA without those complex tax consequences.

To avoid MLP tax headaches, investors are flocking to the Alps Alerian MLP ETF, with assets of $4 billion. The ETF is structured as a C corporation. So retirement savers get a 1099 tax form and can put the investment in an IRA.

There is a tradeoff, however, for investing in C corporation investments. The Alerian MLP ETF accrues deferred tax liability associated with the capital appreciation of its MLP investments and distributions. The ETF’s accrued deferred tax liability is reflected each day in the fund’s net asset value. As a result, the fund has dramatically lagged behind its index, according to a report by Morningstar Inc., Chicago.

Despite the pitfalls, Bellamy, of Robert Baird, says the positive outlook may outweigh some MLP negative traits. Reasons: MLPs are exhibiting low correlations to other assets. They are getting attractive asset-based loans from banks. In addition, some companies are buying energy assets at attractive prices due to low natural gas prices and concerns about changes in the long-term capital gains tax rate.

“Wide-open equity markets enable MLPs to continue acquiring sound assets in attractive deals,” Bellamy says. “Uneven global macroeconomic outlook and unprecedented monetary policy accommodation worldwide should continue to reward securities with highly recurring cash flows and regular dividend returns like MLPs.”