The search for high income asset classes – MLPs, a viable alternative for investors within their asset class mix

As mentioned in PART I of this paper, we started off with providing some information about the basics of MLPs and explained the performance attributes. In this part we will explain how MLPs can be purchased, will pinpoint to the inherent risk factors and will provide an outlook for the asset class.

How can investors get exposure to MLPs?

The most obvious way to invest in MLPs is to buy them directly on an exchange as every other common stock. However, as investors have to weigh the various risk factors of a direct investment. Since 2007, they can choose besides closed-end funds to invest in hedge funds, mutual funds, ETNs, ETFs with a range of different preferences and objectives. Based on our research roughly 10 different ETNs, 8 ETFs and 20 mutual funds came to the market. Overall, Alerian is calculating approx. 75 different MLP-pooled products that are available for US investors as of today and numbers counting. With the securitization of MLPs, the demand has increased as many investors have felt more comfortable to invest in a pooled vehicle. This step has provided another boost on the demand side in recent years. It can be easily envisioned that more products will be launched in the future as the supply and demand side will increase further over time.

However, as investors are considering a pooled vehicle they are urged to consider the replicated universe, fees, tracking error, liquidity, leverage, credit risk of the issuer, and tax treatment, among other issues.

High income potential, but what are the associated risks?

Taking about the opportunity of investing in MLPs, it is important to take the risks and drawbacks into consideration. Like any other investment vehicle, there are unique risks to investing in MLPs, such as limited controls, conflict of interest, cash flow, balance sheet leverage, liquidity, energy sector concentrations, cost of equity, capital markets and tax risks.

While these risks need to be evaluated on an individual MLP level, we believe it is important to point out risks that investors fear the most and would –right so– ask before considering an investment, such as the behavior during a period of (1) interest rate rise, (2) credit spread widening and (3) change in commodity prices.

  1. (1)  MLPs have historically exhibited a low correlation to Treasury yields, however, as seen in summer last year, a rapid, dramatic move upward in Treasury yields may create some near-term pressure on pricing. These short-term shocks are usually short-lived and investors should look at the long-term perspective. Higher finance costs are usually bad for CAPEX which could lead to future lower expected cash flow. However, successful GPs have proven over the years to manage MLPs with expected returns well above the cost of capital and were able to increase payouts over time resulting in historically outperformed fixed income instruments in periods of rising rates. 
    Nonetheless the sensitivity depends mainly on MLPs' interest expense and the impact on their equity values. For those with a long-dated fixed rate debt structure the sensitivity is much lower than for those utilizing a high degree of floating rate debt instruments.
  2. It cannot be neglected that MLPs have historically exhibited a relatively high correlation to major credit spread events. This is because MLPs pay out a quarterly distribution, and one of the main investment points of MLPs is the income generated feature of ownership, comparable to a higher yielding bond. If credit spreads are widening in a flight-to-quality scenario, MLP valuations will most likely get negatively impacted in the short term; in the mid-term, as long as MLPs demonstrate to continue to be on a growth trajectory, a revaluation should happen.
  3. The effect of commodity price changes depends on the exposure of the MLP; downstream and upstream MLPs that are involved in exploration and production have the highest exposure and are thus more likely to be subject to risks; the most resilient segment to commodity pricing is in the midstream segment as they display almost a resemblance to a toll-road business model: providing infrastructure and getting paid just for offering capacity with long-dated contracts which gives them reliable cash flow without commodity exposure and mitigates credit risk as commodity prices fluctuate.

All in all, investors have to familiarize themselves with the embedded risks of MLPs and the external risk factors that can influence the future cash flow stream. It is even more important today to have a detailed review particular on newer MLPs that had their IPO within the last two years as many diverge from the straight forward model and adopted i.e. a variable distribution model and may have high cyclical risks embedded.

How will the asset class evolve over the next years?

In general, last year the combination of reduced domestic demand and improved domestic production growth let to a domestic oil production that exceeded the imports for the first time since 1994. The aim of the US to get energy independence and to become a net exporter of energy in a couple of years is underpinned by the some USD 5bn in budgetary funding for energy research as well as the pending American Energy Renaissance Act of 2014 that is intended to pass legislation this year. This bill is all about 1) removing barriers to develop domestic energy resources, 2) building energy infrastructure, and 3) expanding trade to increase employment and not to forget assist international allies. It is intended to free up the private sector and to get the government out of the way. In fact, it can be argued that while the sector is already booming, the energy industry will get further tailwind in this country and has the potential to grow to become a main pillar of the future domestic economy. Resource development has been growing and will grow more rapidly in the US than anywhere else in the world, and it has triggered a renaissance in America’s energy and manufacturing sectors.

The Interstate Natural Gas Association of America (INGAA) supports this view as they estimate in their updated study from 2011 that some USD 641bn of capital expenditures will be required in the midstream energy space over the next two decades to meet expected customer demand. Interestingly, this study is an update from their previous work two years ago when they estimated it just at USD 205bn.

The outlook for the US energy sector provides an excellent backdrop of continuing robust activity in the MLP space, absent major constraints in the capital markets. We view this as a favorable environment for investing, particularly in the midstream energy segment, which has the ability to continue to grow unabated over a long period of time, sustained by both domestic consumption and export demand at significant rates. It seems therefore obvious that MLPs will perform a major role in developing the infrastructure to support growing supply. MLPs have, in our opinion, proven to be excellent stewards of capital and we anticipate that MLPs will continue to provide attractive total return opportunities based on their current cash flows and distribution growth potential. Therefore, more investors will most likely discover MLPs as an additional asset class that is able to combine an opportunity for a superior yield relative to other investment choices, as well as a growth story.

We view MLPs as a very attractive alternative to infrastructure funds with more advantageous features such as daily liquidity, good visibility of earnings and cash flow projection, steady and continuous increase of compelling distribution. Although MLPs are subject to a certain amount of risk and it can be tricky to understand the full array of possible tax implications for investors (as each investor’s tax situation is different, the opinion of a tax advisor should be obtained before making an investment) it is the belief of PLEXUS that investors should consider MLPs as an additional asset class within their portfolio construction. We would welcome getting in touch with you to discuss the strategy in more detail and to consider how it could be implemented within your asset allocation.

Über den Autor

  • Matthias Kirchgässner

    Matthias Kirchgässner

    Senior Analyst/Partner

    Bevor Matthias Kirchgässner, Dipl. Betriebswirt, seine eigene Gesellschaft Cross Atlantic Alternative Asset Consulting gründete, war er als leitender Produktmanager für kundenindividuelle Hedge-Fonds-Portfolios bei Allianz Hedge Fonds Partner in San Francisco, Allianz Alternative Asset Management und der Nachfolgefirma NEXAR Capital in New York tätig. Als selbständiger Berater ist er auch für die PLEXUS Investments AG tätig.

    Davor war er als Produkt Manager bei der ehemaligen Deutschen Investment Trust (dit) und Allianz Global Investors (AGI), verantwortlich für strategische Produkte, Produktentwicklung und Implementierung in Frankfurt. Er startete seine Karriere als Berater für große Privatvermögen bei der Dresdner Bank in Köln. Insgesamt verfügt er über mehr als 17 Jahre an Erfahrungen auf dem Finanzmarkt und im Asset Management.

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