Master Limited Partnerships—An Alternative Path to High Yields

By Nancy Zambell, Contributing Editor

Are you looking for consistent income without the large investment of bond purchases or the fluctuation of bond funds? If you answered yes, then you may want to consider a fairly-unknown, but generally high-yielding vehicle – the master limited partnership (MLP).

MLPs are publicly-traded limited partnerships, which saw a boom in the late 1970s and early 1980s. Their initial mission was to act primarily as real estate financing vehicles, rolling up smaller partnerships. But they caught the attention of the oil and gas exploration and development companies, and soon branched out to a wide variety of industries in North America.

And like good things, the market became filled with excesses and many MLPs – especially those in cyclical industries – went out of business, resulting in increased regulation. Restrictions to eliminate preferential tax treatment for many MLPs were enacted with the Tax Reform Act of 1986 and the Revenue Act of 1987, subsequently reducing the number of MLPs in the marketplace.

According to the National Association of Publicly Traded Partnerships, an MLP must generate at least 90% of its income from qualified sources, most of which pertain to interest, dividends, real estate rents, gain from the sale or disposition of real property, income and gain from commodities or commodity futures, and income and gain from mineral or natural resources activities. Today, most MLPs are in the energy, lumber, financial services and real estate industries, with some 73% operating in the energy field.

A September 2007 Standard & Poor's report stated that the U.S. MLP Market has grown by more than 150% in the last six years. The industry's market capitalization is now over $200 billion, and it is primarily populated by companies whose assets produce steady cash flows in very stable, slow-growing parts of the energy industry, such as pipelines and storage terminals.

Advantages of MLPs

Unlike equity buyers who purchase shares in a corporation, investors in MLPs buy units of the partnership and are called unitholders. The MLP then 'passes-through' its income, gains, losses and deductions, through distributions, to its unitholders, which turns out to be a big tax advantage.

Because of the pass-through feature, income from an MLP is not subject to corporate income taxes. Instead, owners of an MLP pay taxes on their individual portions of the distributions, which, eliminates the "double taxation' that is levied on most corporations (when the corporation pays taxes on its income and then its shareholders pay taxes on the dividends they receive).

That means more money to send through to the unitholders. And that leads to another advantage for MLPs. The distributions – average 6%-8% annually (but are generally distributed quarterly) for most MLPs – and can add up to a nice chunk of change.

Additionally, because the returns of most MLPs have low correlations with stocks and bonds, MLPs make good sense for investors wishing to diversify their portfolios, perhaps offering some protection from volatile markets and often returning large rewards when stocks and bonds are not.

That concept is demonstrated admirably in the earlier-mentioned S&P report, which stated that from July 31, 2001-July 31, 2007, the total annual returns for bonds, common stocks and MLPs were 4.92%, 5.57% and 17.10%, respectively.

Of course, cash distributions are not guaranteed. And one more caution to unitholders: There are significant tax reporting differences between MLPs and shares of equities:

• Even if you do not receive a cash distribution, you may be taxed on your proportionate share of the MLP income

• Usually, your initial tax basis is the amount you pay for the units. Your basis can be decreased with each distribution and allocation for losses or deductions, and increased for each allocation of income. And very importantly, portions of some distributions may qualify as a return of capital, reducing your taxable basis.

• Unitholders must file an IRS Schedule K-1 each year to report your allocated income, gain, loss, deduction, and credits.

Yet the tax advantage, the high yields and the general consistency of cash flow growth make MLPs very attractive for many investors.

How to Evaluate an MLP

But before jumping in, investors in MLPs need to feel confident that the high cash distributions of the MLPs they purchase will be stable and ongoing. Consequently, it's imperative that you evaluate the MLPs ability to meet those obligations. To determine this, many analysts utilize a distributable cash flow coverage ratio of at least 1:1. The formula is distributable cash flow per unit (cash flow before accounting adjustments) divided by distributions per unit.

Therefore, you will want to seek MLPs with growing earnings, which usually means growing distributions. An easy way to compare MLPs is by using a screening tool, such as that found at:
 http://screen.yahoo.com/stocks.html.

You will also want to consider their dividend growth history, which will often give you a feel for where the company is headed in the future. Next, read the company's annual and quarterly reports to determine its future growth plans.

Make sure you understand that often, assets of MLPs can create large depreciation charges which are subtracted from reported earnings, but which do not result in decreased cash flow – the critical number from which the MLPs distributions are calculated.

And of course, it's crucial that your MLP is financially strong. So make sure its debt to equity ratio is not out of hand. Experts generally like to see this ratio below 55% for most MLPs.

Lastly, you may want to avoid MLPs that have commodity exposure, such as propane or coal MLPs. A safer bet may be pipeline companies, since their fees are set by regulators and tend to be stable.

Of course, you will also want to take into account the general economic climate before you invest in an MLP. Historically, MLPs do better when interest rates are low, like they are now, as MLPs generally will have higher yields than bonds and money market instruments during those periods.

You can get a good idea of how MLPs are faring by taking a look at one of the MLP indexes, such as the BearLink Alerian MLP Index ETN, the S&P MLP Index or the Citigroup MLP Index.

After that, it's up to you. If you wish to add a little income to your portfolio, MLPs may be right for you. Just make sure you thoroughly research your candidates, and don't be bedazzled by the highest yielders at the expense of strong MLPs that pay very good – but not always the highest – of distributions.

This concludes this week's issue of Financially Fit.  We encourage you to visit our website to review past issues of Financially Fit:

http://www.brokeradviser.com/newsletter.cfm

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