Must-know: Why interest rate movements affect MLPs
Why Janet Yellen’s nomination and dovish Fed policy help MLPs (Part 1 of 2)
Interest rates affect MLP prices
Investors who hold master limited partnership (MLP) stocks such as Kinder Morgan Energy Partners (KMP), Enbridge Energy Partners (EEP), Enterprise Products Partners (EPD), and MarkWest Energy (MWE) or MLP ETFs such as the Alerian MLP ETF (AMLP) often monitor interest rates on Treasury bonds. This is because many investors hold MLP stocks for the distribution or “yield” component of the securities. US government Treasury yields are relevant because if rates on the bonds increase, investors should expect distribution yields on MLPs to theoretically increase as well. This is because many view US Treasuries as one of the safest yielding investments in the financial universe, and if the rates on Treasuries increase, the yield required from MLPs (and all other yield instruments) should also theoretically increase. When the yield on MLPs increases, the price and valuation of MLPs decrease.
Lower Treasury rates also push investors to “hunt for yield”
Plus, when yields on instruments such as Treasuries decrease, they also push investors seeking current income into other instruments, such as corporate bonds and MLPs. So, as Treasury yields decrease, yields across the bond sector and higher dividend stocks such as MLPs also tend to decrease.
Higher interest rates can also affect the cost of financing for MLPs
MLPs rely heavily on external financing (see Why master limited partnerships rely heavily on external financing) and often raise money through the capital markets. Higher interest rates mean that borrowing money (raising debt) will be more expensive, because MLPs must pay more cash out for interest expenses to borrow the same amount of money, which negatively affects earnings. Higher interest rates could also mean raising money through issuing equity. This could be more dilutive to shareholders because if the required yield on holding MLP stocks is higher, the prices investors are willing to buy at are lower. This means MLPs must issue more units to raise the same amount of capital.
Historically, MLP yields have moved with Treasury yields
Except for the financial crisis, when investors pulled money out of riskier investments such as equities (including MLPs) and poured it into cash and Treasuries, MLP yields have often moved directionally the same as Treasury yields.
Treasury yields are close to long-term lows right now due to Fed policy
Treasury yields had been close to all-time lows for a while, as the Federal Reserve has been engaging in “quantitative easing.” That is to say that the Fed has been buying $85 billion a month of bonds in the open market, increasing the demand and price of the bonds, which decreases the yields (interest rates). Consequently, yields on fixed-income instruments across the financial universe have become very low in a long-term context. Currently, the ten-year Treasury is yielding 2.50%, and earlier this year, it was yielding as low as 1.60%. For the few years leading up to the financial crisis, after which the Fed acted to keep rates as low as possible, the ten-year Treasury usually yielded in the 4%-to-5% range.
For more on why the interest rate on the ten-year Treasury nearly doubled this year before coming back down, see the next part of this series.
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