Master Limited Partnerships, also referred to as MLPs, are potentially an excellent option for those investors who are focused on income.
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Master Limited Partnerships are legally considered to be partnerships. Because of this, even though they are traded like normal stocks, on the corporate level, MLPs do not have any federal or state income taxes—the tax benefit of a partnership. Rather than shares, investors are purchasing “units” of the partnership and are referred to as “unitholders,” not “shareholders,” as with traditional stocks.
Not paying corporate taxes gives MLPs more available cash to finance distributions. If a firm earns 90% or more of its income through activities and projects related to commodities, real estate, or natural resources, it can become an MLP. This requirement means that many MLPs are North American slow-growth businesses like storage terminals and pipelines for energy companies.
Investors who are looking for long-term capital increases should not look to MLPs. Because the companies that comprise MLPs are slow-growth businesses, they are unlikely to see long-term appreciation of capital. MLPs, though, are extremely stable—slow growth lends itself to resistance to volatility and external forces. Although MLPs are traded on the market like traditional stocks, they are far less mercurial than most natural resources stocks because they ordinarily lack reliance on commodity prices in order to generate revenue. MLPs also traditionally have yields that are significantly higher than most bonds or on the equity markets.
MLPs have shown significant returns. In 2013, the Alerian MLP had a ten-year average annual total return of over 16%. Compared to utility stocks, which returned just under 10%, and the S&P 500 Index, which returned just over 7%, the difference is fairly dramatic. It is important, as always, to keep in mind that these are past returns and can only be used as a benchmark—future returns are in no way guaranteed.
MLPs have a few areas of risk. The first of these is sensitivity to regulatory risk. Because MLPs are inextricably linked to the tax code, any changes to the code will affect the MLP returns. Were the tax code to become more stringent on tax benefits for MLPs, the price of the partnerships would decrease. It is unlikely that these regulatory changes will occur, but it still is a factor that should be taken into consideration when investors are considering a purchase. The second area of risk for MLPs is interest rates. When interest rates are higher, or when interest rates are rising, MLP returns tend to be decreased. Investors often elect to move their money to higher risk, higher return areas of the market when rates are lower, and MLPs, being a fairly stable investment, tend to suffer for it. Similarly, when interest rates are high, MLPs tend to be more appealing and garner higher returns as investors seek out lower-risk investment options.
Investors who are interested in purchasing MLPs can use a broker or can purchase closed-end funds (a collective investment fund which has a fixed number of shares), or exchange-traded notes (also called ETNs). They are also available for purchase as exchange-traded funds (ETFs) like the Alerian MLP exchange-traded fund.
It is essential that investors who are purchasing MLPs discuss the purchase with a tax advisor in advance. MLP owners (who do not own units of the Alerian MLP ETF) must file a K-1 tax form annually.
MLPs tend to behave independently of the larger market—they are not usually subject to the volatility of the other areas of the market in general. This makes them an excellent way to increase portfolio stability and diversity. Before making any investment decision, investors should always research their purchases and discuss concerns with a professional advisor, particularly when factoring in the unique tax considerations of MLPs. For investors seeking a significant yield from a relatively stable investment, Master Limited Partnerships may be an investment worth exploring further.
About Lawrence Meyers
Larry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at firstname.lastname@example.org.Want to learn how to generate more income from your portfolio so you can live better? Get our free guide to income investing here.