MLP ETFs: A Solid Play In Lieu Of T-Notes

More than a fifth of all the exchange-traded products launched so far in 2013 have been focused on master limited partnerships (MLPs), as investors continue to pour assets into a segment that promises solid income potential at a time when many bond yields look paltry and bond prices look stretched.

Two MLP ETFs and two MLP ETNs have come to market this year, beginning with the Barclays-backed iPath S&P MLP ETN (NYSEArca:IMLP) on Jan. 4. Since then, the Global X Junior MLP ETF (NYSEArca:MLPJ), the Yorkville High Income Infrastructure MLP ETF (NYSEArca:YMLI) and another Barclays-based ETN, the Barclays ETN+ Select MLP ETN (NYSEArca:ATMP), have followed.

The latest additions entered a space that's anchored by the veteran JP Morgan Alerian MLP ETN (NYSEArca:AMJ), which was first launched by Bear Stearns then rebranded four years ago after Bear's demise. The new securities further slice and dice an asset class that's now accessible to ETF investors via 17 exchange-traded products, the majority of them ETNs. Their annual expense ratios range from 0.45 to 1.45 percent.

MLPs are U.S. energy assets that were created in the mid-1980s by an act of Congress to encourage private investment in U.S. energy infrastructure, and have been used by many as safety investments, much like an allocation to U.S. Treasurys. A big part of that is that MLPs are known to deliver yields in excess of 6 percent, while yields on 10-year Treasury notes-while rising in recent months-are still around just 2.5 percent.

Most, if not all, MLPs have toll-like revenues from things such as pipelines, meaning they aren't affected by swings in oil and natural gas prices. The MLP class has grown at 25 percent rates in the past decade and now spans assets valued at $375 billion, according to estimates in the industry. Given expanding energy production in North America, that growth is likely to continue strongly, industry sources say.

They're essentially partnerships that trade on a stock exchange like a corporation, but without federal income tax liability at the entity level. MLPs are exempt from paying corporate income tax because they derive the majority of their income from energy-related activities.

At the end of the day, they are "pass through" vehicles, much like REITs, and as such, they don't pay corporate income taxes, which allows them to pass through higher yields to investors. Because of that feature, they have grown in popularity with investors who are looking for income at a time when low-interest-rate policies have compressed yields in the more traditional fixed-income space, notably Treasurys.

It's worth noting that MLP ETFs have different tax treatment than MLP ETNs, the main difference being that ETFs are C-corporations and ETNs are corporate debt obligations.

That means ETFs generally do a better job at passing through tax-efficient income than an ETN would. That said, ETNs are best at replicating the total return of the underlying partnerships because there's no corporate tax drag in the note structure.

The downside of ETNs is also the exposure to issuer credit risk, while ETFs come with the drawback that a C-corporation has to pay corporate income taxes, and that takes a bite out of total returns.

The Energy-Centered Income Play

Either way investors choose to go about tapping into MLPs, the asset class has seen stellar growth, coming in at about a 25 percent compounded annual growth rate in the past decade.

That expansion has been mostly driven by total return and new IPOs, which have boosted the asset class from 20 names to 100, again, for a total market capitalization of about $375 billion, Darren Schuringa, who runs Yorkville's MLP ETFs, said in a recent webinar.

"Having said that, the best days are in front of us," Schuringa said.

That outlook is tied mostly to the expansion of the U.S. and Canadian energy industry, which is driving this growth rate, as Schuringa pointed out.

"North America is the new Middle East-it's the fastest-growing oil and gas producer globally," he said. "It's forecast that the U.S. will be energy independent by 2020."

"The U.S. domestic market is struggling to find sources of growth, and one of the areas that represents large transformational opportunity is an energy renaissance in the U.S. for both natural gas and oil," Global X's CEO Bruno del Ama told IndexUniverse.

Global X sponsors two MLP ETFs, including the cheapest in the space-the one-year-old Global X MLP ETF (NYSEArca:MLPA), which costs 0.45 percent, or $45 for each $10,000 invested.

Ongoing and projected investments in expanding the U.S. energy infrastructure are behind much of the growth in the MLP segment, with "record levels of organic growth spending" taking place, Atlantic Trust portfolio manager and managing director Adam Karpf told IndexUniverse. Karpf's firm is behind the MLP index anchoring Barclays' newest ETN canvassing the space, "ATMP."

"MLPs don't spend on projects until they've already received long-term fee-based contracts, so there's a lock in that accretion level, which provides visibility for distribution growth," he said, noting some of the key metrics his firm uses when analyzing the segment. "That's why we focus on amount and pace of growth spending in the sector."

From an investor perspective, exposure to MLPs offers access to higher current income, growing income as a hedge against inflation, and portfolio diversification given MLPs' relative low correlations to other segments of the market.

A Yield Bonanza

The asset class is currently yielding about 6.2 percent, Yorkville's Schuringa estimated. In fact, one of his firm's MLP ETFs, the Yorkville High Income Infrastructure MLP ETF (NYSEArca:YMLI), just declared its first quarterly distribution this week, coming in at an annualized rate of 6.5 percent.

"There's no growth in high yield, so it's not an apples to apples comparison. MLPs are truly equities that are growing distributions over time," he said. "A comparison shows that there's a 200 basis point spread to the good for MLP investors relative to utilities, which pay 4.2 percent, and almost a 300 basis point pickup in yield between REITS and MLPs."

What's more, utilities are slower growing in terms of distributions and REITs have more volatile distribution growth, Schuringa added.

MLPs have, in the past five years, grown their distributions by 39.4 percent, which comes to an annualized growth of 7 percent a year-assuming that continues to happen, investors are looking at an asset class that should see income double every 10 years.

"From 2000 to 2010, MLPs saw a doubling of income," Schuringa said. "With total return, 6 percent in current income and a 7 percent growth rate, we are looking at mid-teens total return potential for MLPs."

The attractive income and growth profile is another factor helping the segment grow as it attracts investors who often bypass alternative assets for the safety of fixed income.

"MLPs are well placed to benefit from another 'super cycle' taking place as baby boomers increasingly forgo their traditional asset allocation-where it's become tough to generate income in the current interest rate environment-and turn to alternative asset classes such as MLPs," Global X's del Ama said.

The Risks

Among the chief risks the asset class presents, one of them is directly related to its quick expansion, as Atlantic Trust's Karpf pointed out. The quick growth of the MLP segment in the past decade has attracted some nontraditional assets such as coal assets, propane assets and refining assets, he said.

"We think investors buy MLPs with the objective to get exposure to midstream infrastructure businesses like the pipelines and processing assets," Karpf said. That reasoning is what led the firm to create an index that removes some of the so-called lower-quality nontraditional assets from the mix.

That honed-in focus on midstream names is designed to allow investors to tap into higher-quality, stronger-growth MLPs that carry a low risk profile compared to other assets.

"You can't paint all MLPs with the same brush," said Karpf. "There are differences in quality levels between the subsectors."

From a more macro perspective, investors also need to keep an eye on interest rates-a sharp rise in rates would be as detrimental to the segment as MLPs are, in spite of their distinct characteristics, still yield-oriented securities.

Overall weakness in broader capital market conditions is another risk factor given that MLPs are capital-intensive businesses-they require access to capital markets to fund their spending programs since they are pass-through vehicles.

Finally, there's the risk of commodity price exposure, although most MLPs are known for their noncorrelation to underlying commodities.

Still, there are some subsectors in the MLP asset class that carry commodity exposure-mainly exploration and production or refining MLPs-making any sort of move in commodities prices, or even a sharp pullback in crude oil prices potentially negative for the segment.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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