Update on MLP valuation: frothier but not overvalued yet

I an earlier post I talked about MLP valuation and considered if the sector was overvalued. My conclusion was that based on avg historical yield the sector seemed pricey but based on my preferred metric, the yield spread to the 10yr note, the sector was not over valued.

Today I thought I would update the data, considering the recent market advance, and add some more color to the sector’s valuation. As of yesterday the MLP index yield, AMZ, is 6.27% vs a historical avg of 7.84%. The spread to the 10yr note is currently 3.84% vs a historical average of 3.06%. The yield and spread have come down from last month. The sector is definitely a bit more frothy but the spread remains above its long term avg, which tells me we could still see more upside. I put together a chart that shows these relationships.

The left axis is the MLP total return index (blue), AMZX, and the right axis shows the yield of the AMZX index (orange) and the spread to the 10yr note (yellow). If the 10tr note stays flat and the AMZX returns to its historical avg spread to the 10yr, that’s another 20% upside from current prices. Alternatively, the 10yr note could increase 0.78% and the AMZX stay flat to get the spread equal to the historical average. Which will it be? That’s a tough call in the current environment. One one had you have the Fed trying to reflate the economy and on the other you have the private sector trying to de-leverage.

For right now, I’ll stick to my call from last month. MLPs are pricey, getting pricier, but still are not over valued based on one of two important historical indicators. I think they’re safe for a ‘toe in the water’ investment but I’d hold off on any major new purchases in this sector.  I really would love to see a 20%+ correction in this sector – it would represent a great buying opportunity for long term investors. Also, I think there is still individual company value in the sector. In general I think the large cap MLPs are expensive but some of the smaller cap ones are still attractive.

One thing I am considering is that the fundamentals of the sector are changing and that would make historical comparisons obsolete. My biggest question right now is if MLPs are moving from being a niche sector into a stalwart asset class like REITs or utilities. Have investors caught on to MLPs, become comfortable with K-1 filings, looking for more tax sheltered investments etc… If this is happening then it would imply higher prices, lower yields going forward. I don’t know the answer but for my long term wealth I hope this is not true. I want to stay under the radar and compound returns at 15%+ going forward.

Only time will tell. Stay tuned.