Investing in Master Limited Partnerships
MLPs are a fit for yield-hungry yet cautious investors.
Low interest rates are great when you're looking to get a loan or when you're refinancing your home, but not so great if you're looking to earn a return on your money.
A bank certificate of deposit (or CD) pays nearly nothing these days and inflation erodes your gains on tax-free municipal bonds or other government notes. So, to get a higher return, you are being forced to pump up the risk in your portfolio.
Master limited partnerships (or MLPs) could be just the investment vehicle you need before your yield hunger pains get so bad, you start devouring junk bonds. MLPs allow investors to share in the profits of a corporation while deferring the tax bill. This combination has helped many investors get the steady returns they crave, without diving too deep into the risk pool.
What exactly are MLPs and how can you grab a piece of one?
First off, MLPs are not some illiquid mystery investment that trade in the shadows. They are public companies that trade in the open on a stock exchange and can be tracked, purchased, and sold just as easily as you would any other stock. But, unlike the other publicly listed companies, MLPs are unique because they are partnerships and not limited-liability corporations.
This means when you own a share in an MLP, you are seen as a mini-partner in the company instead of just another faceless shareholder. In addition, unlike corporations, MLPs are required to pay out the majority of their income to partners, making them an excellent alternative to high dividend yield stocks.
Being a partner, or unit holder as they are called in an MLP, has its pluses and minuses. The big plus is that unlike other publicly listed companies, MLPs are not taxed at the corporate level, just at the personal level. This allows more of the company profits to flow down to investors.
The bad thing here is that the income you receive is seen by the government as a return on an investment and is therefore taxed at your personal income tax rate, not the lower capital gains tax rate you pay on dividends and other investment gains. But in an MLP, the unit holders can defer paying the taxes on those returns until they're ready to sell their units. This makes for a good long term investment. And since most MLPs generate healthy cash flow, investors usually receive a more consistent and stronger return on their investment in the long run.
Sounds great, but there has to be a catch, right?
Well, MLPs aren't all rosy. Being a partner also has its downsides.
For example, partnership means that you are somewhat liable for any trouble the company finds itself in. So, if the company's profits were deemed, say, to be ill-gotten gains, you would have to pay back your distributions. This liability will follow you forever, so if it is deemed sometime in the future that the company is liable to pay out some damages that occurred while you were a unit holder, then you would have to hand back the cash.
Plus, if an MLP loses money, you can only use those losses to offset future income in the same MLP, as opposed to being able to offset the losses deriving from other investments.
If you are willing to accept these issues, MLP investing might be right for you. Which leads me to….
How does one go about choosing the right MLP?
The vast majority -- around 80% -- of MLPs are centered on the energy industry, specifically the transportation of energy, such as pipeline companies. Pipelines and other energy transportation assets, known in the industry as midstream assets, are usually solid MLP investments because they require minimal upkeep and have strong cash flow.
Their revenues are mostly stable as the demand for energy products, like gasoline and natural gas, remain strong despite volatility in commodity prices. The limited number of pipelines operating in the US means that revenues have a strong competitive advantage, which ensures a consistent payout for MLP investors.
Some of the biggest MLPs are Kinder Morgan Partners (KMP), Enterprise Partners (EPD), and Magellan Midstream Partners (MMP). All three epitomize the midstream MLP structure as they are mainly pure-play pipeline companies with very clear earnings visibility.
There are also MLPs that have riskier energy assets in their portfolios, like mature oil wells and unconventional natural gas fields. While that may seem like they are good candidates for an MLP, they are exposed to commodity price risk, something that the energy infrastructure companies don't have. This risk means your payouts will not be as consistent as they would be with a midstream energy company.
It's important to read the prospectus of an MLP to understand how it generates income from its assets. You want to make an assessment of its ability to meet its cash distribution obligations at a consistent clip.
The Bottom Line
To be sure, MLPs aren't bulletproof investments (neither was your house, by the way). Pipelines can leak, wells can run dry and refineries can blow up – nothing is truly risk free. But, MLPs that have quality assets with strong competitive advantages should keep on yielding slow and steady returns for some time to come.
Editor's Note: This article by Cyrus Sanati was originally published on MintLife.
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