MLPs: What You Need to Know

Investors are looking everywhere for better yields – but how many of them look into Master Limited Partnerships?

Many investors have never heard of MLPs. Others have, but assume they are complex and esoteric. In reality, investing in MLPs isn’t that mysterious. They trade on public exchanges, and today there are even MLP mutual funds and ETFs.

MLPs have outperformed the S&P 500 in 11 of the past 12 years. In fact, they have left stocks in the dust in terms of annualized total returns. From 2002-2011, the average yearly total return for MLPs approached 16%, compared to less than 5% or less each for the S&P 500* and the DJIA*.

Look at their yields***. At the end of Q2 2012, MLPs were yielding 6.7%. The S&P 500 was yielding 2.2%, the 10-year Treasury was yielding 1.6% and REITs (3.4%) and utilities (4.1%) were yielding less.

Of particular interest is the 5% gap between the yields on MLPs and the 10-year note**. Historically, MLPs have done well when this gap is this large. Since 1999, the gap has averaged 3.3%.

Almost all MLPs are pipeline businesses. They make money from the processing or transport of oil, natural gas or coal. Thanks to strict environmental regulations, they don’t face much competition – and as they transport these commodities rather than explore for them, they are theoretically less affected by ongoing volatility in commodity prices.

An MLP weds the tax structure of a limited partnership to the liquidity of a publicly traded security. MLPs are designed to pay out nearly all of their free cash flow to investors in the form of quarterly distributions. As MLPs have big depreciation shields resulting from capital expenditures, 80% of their distributions are characterized as tax-deferred return on capital.

There are demerits resulting from this hybrid construction. MLPs are exempt from corporate taxes, and the taxed part of an MLP distribution is taxed as regular income. The tax-deferred part of the payout reduces your cost basis in MLP shares (which are properly called units), and it is taxable when MLP shares are sold. Appreciation in MLP holdings is subject to corporate tax, and MLP investors get K-1 forms instead of annual 1099s.

However, MLP funds aren’t required to make distributions on balance with the distribution rate of the underlying partnerships, or indeed any distributions at all. In other works, when times are tough, these distributions can suddenly stop.

Consequently, MLPs can be problematic for investors with tax-deferred accounts. Expect intensive paperwork at tax time if you own MLP units. Tax benefits from investing in an MLP are contingent on them being considered partnerships for federal income tax purposes. The impact if the MLP is considered a corporation rather than a partnership? In that case, it’s subject to federal taxation, which can diminish the fund’s value.

MLPs attract income-focused investors who want a hedge. Most people invest in MLPs through a holding company. Select ETFs or mutual funds provide alternate points of entry. Offering potential for attractive yield and depending on your tolerance for risk, you may want to look into this underpublicized investment class.