Why stable Treasury yields are neutral for the MLP sector
Risk-free rates should theoretically affect the required return on MLPs
Investors who hold master limited partnership (MLP) stocks often monitor interest rates on Treasury bonds. This is because many investors hold MLP stocks for the distribution or “yield” component of the securities. U.S. government Treasury yields are relevant because if rates on the bonds increase, investors should expect rates on MLPs to theoretically increase as well. This is because many view U.S. 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.
(Read more: Why MLPs provide excellent risk-reward for investors)
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.
Rates on ten-year Treasury increased slightly last week
The yield on the benchmark ten-year Treasury decreased slightly for the week ended August 9, as it dropped from 2.60% to 2.58%. The yield on the ten-year Treasury has risen sharply since early May, when it was trading at around 1.65%, up to levels of ~2.70% before recently retreating back to current levels of ~2.60%.
But rates remain relatively low from a long-term perspective
In the context of a longer time period, Treasury yields had been close to all-time lows for a while. But recently, yields have backed up significantly. The following graph shows historic yields on the ten-year Treasury from the beginning of 2001 to present.
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The low yields over the past few years mostly affect the Federal Reserve pumping money and liquidity into the financial system. However, the markets had started to anticipate an end to the Fed stimulus and a consequent increase in rates that caused Treasuries and other bonds to begin to sell off. Since then, the debt market has recovered somewhat, as there have been further comments from the Fed that curtailments to stimulus measures would likely not come in the short term and it would first have to see improved employment figures. The graph below shows the yields on the Alerian MLP Index versus ten-year Treasury yields.
(Read more: An in-depth look at the mechanics of fractionation spreads and how they affect MLPs)
Historically, MLP yields have moved with Treasury yields
Except for the period of the financial crisis, where investors pulled money out of riskier investments such as equities (which MLPs are) and poured it into cash and Treasuries, MLP yields have often moved directionally the same as Treasury yields.
Positive and negative outlook
Last week, the yield on the ten-year Treasury decreased slightly, which was a positive for MLPs. However, through much of 2Q13 and July, the yields on Treasury instruments had increased to the highest points in over a year, which was a negative medium-term catalyst for the rate-sensitive MLP sector. Lastly, from a longer-term perspective, rates remain relatively low, which has resulted in a long-term positive for MLPs. If rates eventually rise, for example, to pre-recession levels of 4% to 5%, they could be a negative for MLPs and the Alerian MLP Index (AMLP). Major names in the index include Enterprise Products Partners (EPD), Kinder Morgan Energy Partners (KMP), Magellan Midstream Partners (MMP), and Plains All American Pipeline (PAA). So MLP owners should be aware of rate movements and how they affect MLPs.
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