Should You Invest in MLPs to Generate More Retirement Income?

Master limited partnerships ended 2020 as the highest yielding asset class but are arguably the most complicated from an investing standpoint. Investment analyst Ryan Giannotto explains how they work and using them to generate income from your portfolio.
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By Ryan Giannotto, CFA

The “Great Income Squeeze of 2020” has laid bare the limitations of conventional income strategies. A recurring theme was investors, who thought they were set up for perhaps 5% income, watch in despair as their passive cash flows declined to 2%, or even evaporated altogether. Between falling bond yields and aggressive dividend cuts, the traditional approaches to passive income may not be coming back anytime soon, if they return at all.

Ryan Giannotto

Ryan Giannotto, CFA

It is no wonder investors are seeking new income strategies for 2021, and pass-through securities are one of the few sectors of the market that can offer an escape from the low-yield doldrums. These specialized assets contain a one-two punch for boosting investment yields—not only are these assets exempt from corporate taxes, but they are required to pay out nearly all of their earnings to shareholders. The end effect is that corporate cash flows are pipelined directly to end investors, not board members or tax collectors.

Of the four main categories of pass-through securities, master limited partnerships (MLPs), ended 2020 as the highest yielding asset class but are arguably the most complicated from an investing standpoint. As a gauge of income potential, the Solactive MLP Index yielded 11.25% as of Dec. 31, 2020, and that number alone is likely to interest many who are seeking passive income.

Yet as with any investment, long-term goals must be considered as well as the trade-offs an investor is willing to make. There is no free lunch, especially when trying to generate meaningful income in today’s market. Let’s break down the unique characteristics of MLPs, and the potential role they can serve in boosting a yield-starved portfolio.

Alphabet Soup: MLP Edition

What are MLPs, and how were they able to generate over seven times the yield of the stock market as of December’s end? The key to MLPs is how they are a hybrid structure between traditional partnerships and regular corporations—they combine the liability protection of a corporate structure with the tax pass-through treatment of a partnership, all with the liquidity of a conventional stock.

This happy marriage can produce many potential benefits for end investors. The MLP structure was created by Congress in 1981 to allow certain types of partnerships to have easier access to public trading via the stock market. The key barrier to entry was a commitment to distribute substantially all free cash flow (+90%), but once this requirement was satisfied, a company could reorganize and effectively dodge corporate taxes.

The problem was the new structure was so tax advantageous, Congress had to restrict MLPs to only the energy and natural resources sector (90% of revenues must be industry-specific to qualify). Companies piled in on the tax windfall; even the Boston Celtics basketball team reorganized as an MLP to protect franchise revenues from the taxman! While Apache Petroleum Corporation was the first MLP, the space has since grown to 73 publicly-traded entities with a collective market capitalization of approximately $270 billion.

Taxes with Benefits

A standard dictum for optimizing taxes is “pay less, pay differently, and pay later,” and MLPs can employ all three tax minimization strategies simultaneously. Not all income is created equal, and understanding the nuances of how MLPs create a stacking effect to tax benefits can help maximize the value of yield distributions to end investors.

Foremost, as with any pass-through security, MLPs can enjoy exemption from corporate taxation—all else equal, this leads to higher return on equity and larger income distributions. The real potential of MLPs, however, rests in their ability to classify much of their distributions, historically 70-80%, as return of capital (ROC). Unlike ordinary dividends, which are taxed as income, return of capital only reduces the cost basis of the investment—the distribution is only taxed if the investment is sold, and then only at the lesser capital gains rate.

This tax sleight-of-hand lies at the heart of the MLP’s appeal. Not only is the distribution converted to a more favorable tax treatment, but any taxation at all may be deferred on a semi-indefinite basis. While MLPs can generate very impressive yields on a nominal basis, the favorable tax treatment renders these distributions, dollar for dollar, ever more appealing.

The reason MLPs can accomplish these feats is that, as partnerships, these entities can pass asset depreciation along to end investors to offset business profits. In other words, while MLPs may generate cash profits through operating gas pipelines, they can claim their upstart infrastructure investments lost value—this loss on paper can be used to lower the tax bill.

How to Use MLPs in the Portfolio

The case for investing in MLPs inevitably focuses on their investment yields, but what are their business profiles, and how should investors consider their potential use? The current MLP ecosystem centers on oil and gas pipelines and distribution (referred to as midstream), and refining activities (referred to as downstream). These business segments are ideal for MLPs, as they entail large fixed investments (so as to maximize asset depreciation potential) and feature relatively stable, predictable cash flows to pass on to end investors.

Operating in the energy sector, a stigma often follows MLPs for their exposure to oil prices and the cyclicality risks. A deeper examination, however, reveals the actual influence of the crude oil market on MLP performance is surprisingly low, a classic example of how popular prejudice often does not reflect the actual hard data. For instance, over the last 25 years, oil prices explained only 14% of MLP returns—while still a notable factor, it is not the overbearing influence commonly presumed.

Why have MLPs maintained a relatively low sensitivity to oil prices over the long term? The midstream oil and gas segment operates on a cost-of-service basis, often with transport capacity being booked in advance. Therefore, their cash flows are tied primarily to volume of throughput and not to the price of oil itself, and overall volumes have tended to be far more stable than prices.

Nonetheless, MLPs were seriously impacted by the pandemic, but their performance as an asset class was not altogether dissimilar from other small-cap companies with limited capabilities to raise financing. These sharp declines presented a potential opportunity to purchase income-producing assets at an historic discount, and prices have recovered particularly following the vaccine distribution. To be clear, MLPs should not be employed as growth investments, but a broader economic recovery may enable an opportunity for capital appreciation potential.

An Income Pipeline? MLP Risk & Rewards

Certainly, MLPs are a risk-based asset optimized toward generating high income potential. Oftentimes, this is a point of confusion for many investors, as traditional models emphasize safety of investment for achieving income goals. However, this idealized vision of a low-risk asset that produces livable income no longer exists in practice—it is effectively a figment of imagination.

When factoring inflation and tax regime increases, this desire for absolute safety in income is increasingly outmoded, if not outright untenable. Furthermore, accepting low income distributions fosters a reliance on an ever increasing stock market to fund retirement goals, a dubious proposition when markets are historically expensive by nearly any valuation metric.

New risks may need to be taken to achieve anything beyond the most modest of income yields, and MLPs may serve an effective part of a broader, diversified portfolio solution. Assets should be judged against their intended purpose, and as a yield producing investment, MLPs offer unique exposure to real economy cash flows. Over the past 20 years, approximately 90% of MLP returns emanated from income distributions, only 10% from capital appreciation. Playing to their strengths of tax-optimized distributors of potential yield, MLPs may help diversify passive income streams while materially boosting portfolio yields.

About the Author: Ryan Giannotto, CFA

Ryan Giannotto, CFA, is the Director of Research at GraniteShares, a New York-based independent exchange-traded fund issuer that seeks to launch innovative and disruptive ETF investments. At GraniteShares, Ryan focuses on portfolio construction, indexing strategies and the use of non-correlating assets. He graduated from the Honors Program at Boston College with a B.A. in economics and philosophy.

Past performance is not a guarantee of future results. One cannot invest directly in an index. For full disclosure, GraniteShares manages the GraniteShares HIPS U.S. High Income ETF (HIPS), which invests in a basket of pass-through securities.