NEW YORK (TheStreet) -- The market volatility that started this year has led investors to seek out safe havens and has led to a retreat in interest rates. The 10-year Treasury is 40 basis points off its high of 3% reached in December.
The drop in rates has resulted in a strong bid for higher yielding equity investments such as real estate investment trusts, utilities and master limited partnerships, all of which gained in January while the S&P 500 dropped 3.5%.
If you believe this recent pullback in rates is a short-term blip, income-oriented equity investors need to be particularly selective in their stock picking and focus on distribution growth.
Distribution growth offers three primary benefits: (1) preserves purchasing power which functions as a hedge against inflation, (2) offers protection against rising rates and (3) drives future price appreciation.
Many investors are aware of the high current yield offered by master limited partnerships, which generally fall into the 5% to 8% area. However, fewer pay appropriate attention to future distribution growth and what it can mean to their investments over time.
Let us look at a simple example to illustrate the power of distribution growth:
Vanguard Natural Resources LP (VNR - Get Report) is a successful exploration and production (upstream) MLP that offers a current annualized yield of nearly 8.5%, while Atlas Energy LP (ATLS) is a general partner MLP with an indicated yield of 4.0%.
Given the need for current income, an income investor might choose to invest in VNR. In this scenario, the income investor has neglected forward growth rates and its effect on price appreciation
VNR has grown its payout at an annual rate of about 4% over the last three years and is projected to grow at a rate closer to 2% going forward. ATLS, meanwhile, has grown its distribution at an exponential rate in recent years and analysts estimate 20% distribution growth for the next three years.
All else being equal, the income stream of a $100 investment in VNR (at 4% growth per year) vs. ATLS (at 20% growth per year) is equal after five years.