MLPs: maybe the best income investment

MLPs, or master limited partnerships, are a type of company structure that was created by an act of congress in 1986 to encourage investment in the natural resource and energy sector. They are income pass-through entities, i.e. they pay no corporate tax and pass most of their profit on to share holders (called unit holders in MLP parlance). For a great and detailed background on MLPs I can’t do much better than refer you to a series of articles on Seeking Alpha by Richard Shaw. See here for part 6 of the series.

Currently, MLPs play a central role in my portfolio and I think are one of the best income investments out there. There is a major natural gas supply boom taking place in the US and while not great for natural gas prices it is great for natural gas demand. MLPs are playing a major role in this boom building out much of the needed infrastructure.

Why are they good income investments? Several reasons; they offer high current yields (currently about 6%), tax deferral, stable cash flows in various economic environments, and the opportunity for income growth. The Alerian MLP index, AMZ and AMZX tracks the MLP sector. Returns over the last 10 years have been nothing but stellar; 10yr CAGR of 18.5% vs -1.5% for the S&P500! What lost decade??

What are the potential downsides? Well, the gov’t could decide to take away the special tax status though most experts currently do not consider this a big risk. If anything the gov’t wants to encourage more energy investments. Second, tax filing for MLPs can be complicated due to the K-1 tax forms sent to investors (its really not that bad I think). Third, MLP stock prices have been as volatile as the S&P500 index. This volatility has presented fantastic buying opportunities but it is something to consider. Lastly, returns in the next decade are likely to be lower than 18.5%. The last decade was fantastic but I think with current yields of 6% and even 3-4% income growth, MLPs can generate 10% annual returns with tax deferral. Not too shaby!

I tend to focus on the larger cap MLPs with stable cash flows and lots of liquidity such as KMP and EPD. I also tend to stick with the pipeline and midstream MLPs, again for the stability of their cash flows. For example, during the financial crisis neither KMP, EPD or many other large MLPs cut their dividends. In fact many kept dividends growing in the ‘worst recession since the great depression’.

As with other income  investments MLPs have become popular so there is some concern in the investment community that the MLP sector is frothy; that the stocks too popular and are over valued. I will address this in my next post.

Disclosure: long EPD, KMP.