Are MLPs overvalued?

As promised in my last post, I want to address the concern that MLPs at today’s prices may be overvalued.

There is no doubt that investing in MLPs has received increasing attention this year. This has been true of all income investments particularly bonds in the face of such low yields on savings and fear of the stock market. An example of some of the concern can be found here. An excerpt;

Wall Street is going crazy for MLPs these days!  The safe, stable, dividend yield of a master limited partnership (MLP) is all the rage right now with investors.  Which is precisely the reason you might want to steer clear of this sector for a bit.

What has generated much of this concern is the launch of several new ETFs or ETNs specifically focused on MLPs. A summary of this trend for more MLP ETFs can be found here. The big new ETFs are AMLP, MLPN, and MLPL (a 2X ETF for god’s sake). Also the MLP ETF index, AMZ is up about 21% in 2010 vs a flatish S&P500.

So, definitely cause for concern but I like to verify the concern with hard data to see if its merited. First thing I did was to look at trading volume for the largest MLPs. Firms like KMP, EPD, and ETP. Here’s the chart from the big kahuna in the MLP space, KMP:

Looking at the volume graph in the lower section shows no uptick in volume at all. If anything volume seems to have gone down. The charts for the other big MLPs look the same. The hot new ETF trend doesn’t seem to be having much effect. Thus I don’t see the effect of all this supposed popularity in the trading of these stocks.

Now to look at valuation I think the best way to judge MLPs is to use their current yield vs historical averages and the spread between their current yield and other income investments. The benchmark for other income investments most commonly used is the yield on the 10yr US Tresury bond. Lets take a look at the AMZ index:

Current yield: 6.68%, average historical yield: 7.86%

Current spread to 10yr: 4.39%, average historical spread to 10yr: 3.05%

Based on the comparison to historical yields the index does look slightly overvalued but the spread to the 10yr bonds is above the historical average which says the index is not overvalued. So, which is it?

Ideally both these metrics would be signaling undervalued before a purchase of MLPs and a conservative investor can wait for such a time. I’m sure it will come. However, based on the spread to the 10yr note (a metric I prefer) I do think an investor looking to generate income today can put a toe in the water in the MLP space and generate forward returns of 9-10%, the current yield of 6.7% plus a conservative 3% of income growth.

For an investor, such as myself, with a significant position in the MLP space, I would recommend continuing to reinvest the dividends from current holdings and to wait before committing new money to the MLP space. That’s what I’m doing.

Discloure: long KMP, EPD, ETP