MLPs Top the Yield Charts, but Don't Overlook the Risks

With bank and money market rates bumping along between 1% and 2%, 30-year Treasury yields barely edging above 4%, and many old standby companies having slashed or eliminated their dividends, it's been a rough year or two for income-oriented investors.

As a result, many have turned an eye toward Master Limited Partnerships (MLPs), virtually the only game in town with the potential to give you a double-digit yield on your cash.

MLPs, for those not familiar with them, are tax-advantaged limited partnerships whose units are traded on stock exchanges, just like the regular common shares of corporations. MLPs provide very high yields - typically 5% to 12% - because U.S. law mandates that they pass most of their income on to unit holders. As such, it's not taxed at the partnership level.

This tax advantage was granted by Congress after the Tax Reform Act of 1986 eliminated most other types of tax-sheltered investments. However, the government severely limited the kinds of businesses that can use the MLP structure, restricting it primarily to operations engaged in the extraction, storage and transportation of petroleum products and other natural resources (such as coal) that are deemed essential to the U.S. economy and national security.

As a result of those limitations, the bulk of the more than 90 existing MLPs are pipeline businesses, which earn very consistent and stable income from the transport and storage of oil, natural gas and gasoline - an example being El Paso Pipeline Partners L.P. (NYSE: EPB).

There are, however, some exceptions. A few private equity and fund-management companies -such as Fortress Investment Group (NYSE: FIG) and The Blackstone Group L.P. (NYSE: BX) - are structured as MLPs, as are several real estate ventures, like New England Realty Associates L.P. (AMEX: NEN). Oddly, the Boston Celtics of the National Basketball Association were reorganized as an MLP in the late 1980s.

Although most financial Web sites and quote services list the MLP payouts as dividends, they're actually not. Instead, they're classified as "quarterly required distributions," or QRDs. The amount of the distribution is specified as a percentage of income in the contract between the investors (or unit holders), who are actually limited partners, and the "master" partner, who manages the enterprise.

The master partner (or general partner) takes a management fee, of course, and is allowed to deduct certain operating expenses prior to making the distributions. While the actual dollar amount of the distributions can vary with changes in the MLP's income, any suspension of distributions would be considered a contractual default by the managing general partner.

Just take a look at the kinds of payouts and yields these six energy-focused MLPs provide. But remember these aren't necessarily recommendations - just some starting points for you if you decide you like what MLPs have to offer:

  • Magellan Midstream Partners L.P. (NYSE: MMP), recent price: $48.70 - Trailing annual distribution, $2.88; yield, 5.91%.
  • Sunoco Logistics Partners L.P. (NYSE: SXL), recent price: $77.00 - Trailing annual distribution, $4.46; yield, 5.79%.
  • Genesis Energy L.P. (AMEX: GEL), recent price: $26.30 - Trailing annual distribution, $1.47; yield, 5.58%.
  • Enterprise Products Partners L.P. (Nasdaq: EPD), recent price $37.05 - Trailing annual distribution, $2.27; yield, 6.12%.
  • Teekay LNG Partners L.P (NYSE: TGP), recent price: $31.20 - Trailing annual distribution, $2.40; yield, 7.69%.
  • Vanguard Natural Resources LLC (Nasdaq: VNR), recent price: $24.50 - Trailing annual distribution, $2.10; yield, 8.57%.

One point: Vanguard Natural Resources isn't actually an MLP, but rather a "limited liability company." LLCs are quite similar to MLPs - in both structure and in payouts and yields - but they operate as corporations rather than as partnerships. As such, there's no "master" partner to take a slice off the top before distributions - all the profits go to the shareholders, often equating to higher yields. For tax purposes, however, LLCs are treated the same as MLPs, so they're also worth a look by income investors.

Also similar in structure to MLPs and LLCs are U.S. and Canadian royalty trusts (CanRoys), which focus on companies involved in the exploration for and extraction of natural resources. These offer equally high payouts to unit holders, though the Canadian trusts - an example being Provident Energy Trust (NYSE: PVX) - lost some of their appeal in 2009 when Canada tax authorities unexpectedly altered the trust structure, eliminating some of the prior tax benefits.

Be aware, however, that these large distributions and high yields don't come without some concerns. Key risk factors include:

Price sensitivity to the underlying natural resource - The share prices of a number of MLPs took a hit in May 2010 when oil and gasoline prices declined and the dollar went up against the euro (oil is priced in dollars, so a strengthening dollar makes oil more expensive for those using other currencies). This is a natural market reaction, but the impact is typically not too severe since energy products still have to be shipped, providing steady revenue for pipeline and transport MLPs, regardless of the price of oil.

Interest-rate risk - When turmoil or uncertainty prompts a flight to safety, risk spreads between Treasury securities and other yield-oriented investments, such as MLPs, widen - and that can send MLP share prices lower. Again, however, the impact is lessened by the fact that MLPs have a revenue stream not tied to the credit markets, making them less sensitive to rate changes than regular debt instruments.

The potential for share dilution - Since MLPs (and LLCs) pass all their excess income through to unit holders on a quarterly basis, they never build up any cash reserves. As a result, when they need to finance growth or an acquisition, they typically have to raise the required funds through a secondary stock offering. This influx of new supply may cause prices for existing units to take a temporary hit until revenue from the expansion or acquisition shows up.

Regulatory risk - As holders of CanRoy units found out, governments can change the rules regarding trusts and other tax-favored operating structures. However, given the current energy situation and the mood in Congress, it seems unlikely the United States will change the tax status of MLPs anytime soon.

Return of principle - If MLPs or LLCs see a drop in revenue, for whatever reason, they may sometimes elect to keep payout levels unchanged by including a portion of the unit holders' original investment with the required distribution. While this doesn't impact your cash flow, it does lower your actual yield and forces an adjustment in your cost basis when you later sell and have to figure your capital gains tax liability. Such returns of principle may go unnoticed when received, so be sure to carefully examine the K1 form the MLP sends out at the end of the year (rather than the 1099 form you'd receive for regular dividends).

If income is your top priority right now, then none of these risks outweigh the yield potential of MLPs - so why not give them a look.

Just keep one thing in mind when you do your analysis: With regular dividend-paying stocks, it's important to review the corporate earnings, earnings-per-share (EPS) and cash-reserve numbers to ensure the company has the funds needed to "cover" the dividend payout. With MLPs and LLCs, you'll frequently see stated EPS numbers that are well below the payout level - or even negative. Remember, however, that the QRDs are deducted before earnings, if any, are calculated, so the EPS numbers are essentially irrelevant.

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