Should You Invest in a Master Limited Partnership?

The following post comes from Cyrus Sanati at partner site Mintlife.

Low interest rates are great when you’re looking to get a loan or refinance your home, but not so great if you’re looking to earn a return on your money.

A bank certificate of deposit (CD) pays nearly nothing these days, and inflation erodes your gains on tax-free municipal bonds or other government notes. So to get a higher return, you’re being forced to pump up the risk in your portfolio.

Master limited partnerships (MLPs) could be just the investment vehicle you need before your yield-hunger pains get so bad, you start devouring junk bonds. MLPs allow investors to share in the profits of a business while deferring the tax bill. This combination has helped many investors get the steady returns they crave, without diving too deep into the risk pool.

What exactly are MLPs and how can you get one?

First, MLPs are not some illiquid mystery investment that trade in the shadows. They’re public companies that trade in the open on a stock exchange and can be tracked, purchased, and sold just as easily as you would any other stock. But unlike the other publicly listed companies, MLPs are unique because they’re partnerships, not corporations.

This means when you own a share in an MLP, you’re seen as a mini-partner in the company instead of just another faceless shareholder. In addition, unlike corporations, MLPs are required to pay out the majority of their income to partners, making it an excellent alternative to dividend-paying stocks.

Being a partner (or “unit holder” as they are called in an MLP) has its pluses and minuses.

The big plus is that unlike other publicly listed companies, MLPs are not taxed on the corporate level. Since the MLP doesn’t have to pay taxes, it has more money to share with its shareholders.

The minus is your share of the profits is taxed at your personal income tax rate, not the lower capital gains tax rate you pay on dividends.

Often, however, MLPs send out distributions that exceed their profits. When that happens, those excess distributions are considered a tax-deferred return of capital, which means no taxes are due until the units are sold.

Sounds great, but there has to be a catch, right?

Well, MLPs aren’t all rosy. Being a partner also has its downsides.

For example, while corporate shareholders are generally shielded from management mistakes, partners in an MLP are slightly less sheltered. In theory, creditors can seek the return of distributions made to partners if the money was owed before the distribution was made. And that liability remains even after shares are sold.

Plus, if an MLP loses money, you can only use those losses to offset future income in the same MLP, as opposed to being able to offset the losses deriving from other investments.

If you are willing to accept these issues, MLP investing might be right for you. Which leads me to….

How does one go about choosing the right MLP?

The vast majority – around 80 percent – of MLPs are centered on the energy industry, specifically the transportation of energy, such as pipeline companies. Pipelines and other energy transportation assets, known in the industry as midstream assets, are usually solid MLP investments because they require minimal upkeep and have strong cash flow.

Their revenues are mostly stable as the demand for energy products, like gasoline and natural gas, remain strong despite volatility in commodity prices. The limited number of pipelines operating in the United States means that revenues have a strong competitive advantage, ensuring a consistent payout for MLP investors.

Some of the biggest MLPs are Kinder Morgan Partners (KMP), Enterprise Partners (EPD), and Magellan Midstream Partners (MMP). All three epitomize the midstream MLP structure, as they are mainly pure-play pipeline companies with very clear earnings visibility.

There are also MLPs that have riskier energy assets in their portfolios – like oil wells and natural gas fields. The fields chosen for such a structure are usually wells that are mature, which produce oil or gas at a slow and steady rate.

While that may seem like they are good candidates for an MLP, they’re exposed to commodity price risk, something that the energy infrastructure companies don’t have. This risk means your payouts will not be as consistent as they would be with a midstream energy company.

It’s important to read the prospectus of an MLP to understand how it generates income from its assets. You want to make an assessment of its ability to meet its cash distribution obligations at a consistent clip.

But for investors who can’t be bothered to look into a prospectus but still want MLP exposure, there are three MLP exchange traded funds (ETFs) they can turn to. These ETFs basically pool investor cash and put it to work in several MLPs (like an MLP mutual fund, of sorts). This not only takes the guesswork out of MLP investing but also helps to cut down on the tax burden, as the distributions that are received by the MLP through the ETF are taxed at a lower capital gains rate and not the higher personal income rate.

As with any managed investment vehicle, you should look out for the fees. Some charge their investors a management fee to cover marketing, management, and investing costs.

“We basically determined that the cost we could charge for making an effective product was significantly lower than what exists,” says Alex Ashby, an analyst at Global X Funds. “We charge a total management fee right now of 45 basis points, or 0.45 percent, where the existing products out there are more in the range of 80 to 85 basis points. So we are almost half the cost of the other products out there right now.”

The popularity of MLPs will surely see more ETFs pop up in the near future, which should put further downward pressure on fees.

The bottom line

To be sure, MLPs aren’t bulletproof investments. Pipelines can leak, wells can run dry, and refineries can blow up – nothing is truly risk-free. But MLPs that have quality assets with strong competitive advantages should keep on yielding some slow and steady returns for some time to come.

Cyrus Sanati is a freelance financial journalist whose work has appeared in The New York Times and on WSJ.com. Follow him on Twitter at @csanati.