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Master limited partnerships (MLPs) for income in 2014

By Xavier Brenner

master-limited-partnership-mlp

Master limited partnerships as a group delivered solid returns in 2013 as low bond yields forced many investors to explore fresh pastures in search of income.

The Federal Reserve has announced its long-awaited decision to taper its bond purchases, and 10-year Treasury note yields ended the year above 3%.

ALPS Alerian MLP ETF ( AMLP), the largest exchange traded fund tracking the asset class, posted a total return of nearly 19% in 2013.

However, will Fed tapering and potentially higher interest rates mean MLP investors face a tough year ahead? Not necessarily.

History shows that while MLPs sometimes take a short-term hit during times of big rate moves, these products may perform well longer term. In fact, they have grown extremely popular in the current low-rate environment as investors seek yield and diversification.

Another bullish factor: These products have exposure to one of the hottest sectors in the U.S. economy — energy. MLPs are publicly listed firms involved in the processing, storage and transportation of energy commodities such as oil and natural gas. As of November 1, 2013, there were 106 publicly traded energy MLPs with a combined market capitalization of approximately $430 billion. Many MLPs are paying dividend yields of 5% or more - hence their popularity with income-oriented investors.*

Just like bonds, rising yields can be bad news for MLP prices, which tend to trade in an inverse direction to interest rates. Rising interest rates can also mean higher borrowing costs for the partnerships depending on how much of their debt is variable-rate.

In terms of price appreciation, the benchmark Alerian MLP Index (AMZ), a composite of the 50 most prominent energy Master Limited Partnerships (MLPs), underperformed the S&P 500 Index (SPX) and the Dow Jones Industrial Average (DJIA) in 2013. That said, it still registered 20%-plus gains.

However, Brian Watson, an analyst with OFI Global Asset Management, points out that while MLPs do perform poorly right after an interest rate shift, longer term the sector still fares well relative other asset classes. A useful analogy to the Fed tightening this year may be the 2004-2006 period, when the Fed Funds Rate rose from 1% to 5.25%.

During that period, the cumulative total return experienced by the Alerian MLP Index was nearly 42%, according to Watson.

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