MLPs: An Enticing Alternative to Conventional Dividend Investing

Dividend investing update: With U.S. stocks at all-time highs and the current bull market still going strong after five years, many analysts warn that asset valuations are out of touch with reality and a correction is headed our way. In the event of a market correction, investors will be limited to settling for returns lower than the historical average or seeking out investments that add an extra percentage or two in dividends.

That's why alternatives to conventional dividend-investing strategies are worth a look. They offer high yield and don't always suffer share-price losses during market corrections that some dividend stocks see.

One such alternative is master limited partnerships (MLP), which are limited partnerships that are publicly traded on securities exchanges.

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Gas processing plant: An MLP's revenues must come from commodities, natural resources, or real estate.

Money Morning's Global Energy Strategist Dr. Kent Moors considers MLPs one of the best ways to invest in the energy sector. "From their tax advantages to their high-paying yields, it's hard to beat the returns of a master limited partnership," said Moors.

MLPs are an attractive investment because they coalesce the tax advantages of a limited partnership and the liquidity of publicly traded securities.

General partnerships are remunerated on a sliding scale and garner a larger share of every dollar of cash flow as the limited partners' revenue distributions grow. This prompts the general partner to grow limited partner distributions as part of incentivization.

In order for a partnership to be qualified as an MLP, a majority of its revenue must originate from the processing, production, or transportation of commodities, natural resources, or real estate. This is due to stringent U.S. federal laws applied by the Internal Revenue Service.

As of late last year, only 111 MLPs were listed on U.S. stock exchanges. In spite of the relatively small number of MLPs to choose from, this unique investment vehicle offers a number of benefits.

Let's take a look...

MLPs Provide Benefits Beyond Traditional Dividend Investing

MLPs offer high yields and the potential for growth, even during a recession. The average yield of MLPs falls between 6% and 7%. Also, MLPs offer reliable distributions over time and a lower cost of capital. Companies that utilize the MLP system tend to invest in more stable, slow-growth industries that provide investors with peace of mind.

Another added benefit is that MLPs give investors the opportunity to postpone their personal income tax liability for years at a time. This means that at least four-fifths of the allotment is tax-deferred. These types of limited partnerships allocate most of their earnings to investors in consistent quarterly distributions.

Another major benefit that MLPs offer is room for growth. In the past decade alone, the MLP market cap has soared from a modest $25 billion to an enormous $350 billion, and some experts project that it could very well become a trillion-dollar asset class.

MLPs also serve a critical function in improving the infrastructure of the United States, which is important in light of the U.S. oil and gas boom currently underway.

Last year, MLPs generated substantial returns that averaged between 50% and 173%. Some of these MLPs include EnLink Midstream Partners LP (NYSE: ENLK), Pioneer Southwest Energy Partners (a subsidiary of Pioneer Natural Resources [NYSE: PXD]), American Midstream Partners LP (NYSE: AMID), Hi-Crush Partners LP (NYSE: HCLP), and Emerge Energy Services LP (NYSE: EMES).

Although MLPs are enticing because of their high rate of return and tax advantages, they are not without risks that investors need to be aware of...

Risks Associated with MLPs

Two primary risks are associated with MLPs. The first pertains to potential modification to the tax status of MLPs. Since 2012, U.S. President Barack Obama has been considering a plan that would eliminate the current tax structure of MLPs. Financial experts say it's unlikely to transpire but have warned investors that it is still possible.

The second risk pertains to rising interest rates. Analysts and financial institutions anticipate that the U.S. Federal Reserve will start raising rates as early as 2015 in light of increasingly positive employment figures. The U.S. Labor Department reported that the labor market added 288,000 jobs during the month of June.

Although plenty of MLPs are resilient to fluctuations in interest rates, some MLPs tend to underperform in a rising interest rate environment.

One final concern of MLPs is their limited pool of investors, especially when compared to conventional equities. This is because institutional investors are prohibited from holding units in MLPs without sustaining tax liabilities.

In spite of these risks, MLPs offer investors an attractive alternative to conventional dividend-investing strategies. They rank among the best sources for higher-than-average yields and the best opportunity for share appreciation as both demand and supply of energy continue to rise.

Energy Investing Alert: After more than four decades, America is getting back into the oil export business again. And the end of the U.S. oil export ban is going to be a windfall for these companies...