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Treasury yields inch up slightly, negative for rate-sensitive MLP class

Ingrid Pan, Sr Energy Analyst

Risk-free rates should theoretically affect required return on master limited partnerships

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: An in-depth look at the mechanics of fractionation spreads and how they affect MLPs)

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 the ten-year Treasury increased slightly last week, close to 2013 highs

The yield on the benchmark ten-year Treasury increased slightly last week, as it rose from 2.49% to 2.56% for the week ended July 26. 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%. Currently, the ten-year Treasury is yielding near its highest point in 2013 (2.74%).

But ten-year Treasury rates remain relatively low from a long-term perspective

In the context of a longer time period, Treasury yields were close to all-time lows for a while, though recently, yields have backed up significantly. The graph below shows historic yields on the ten-year Treasury from the beginning of 2001 to present.

(Read more: MLP (master limited partnership) tax considerations)

The low yields over the past few years mostly affect the Federal Reserve pumping money and liquidity into the financial system. However, the markets started to anticipate an end to the Fed stimulus and a consequent increase in rates, which 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 have to see improved employment figures first. The graph below shows the yields on the Alerian MLP Index versus ten-year Treasury yields.

(Read more: Why fractionation spreads affect some MLP stocks)

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.

Last week, the yield on the ten-year Treasury increased slightly, which was a negative for MLPs. Over the past several weeks, the yields on Treasury instruments 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%, it 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). Owners of MLPs should be aware of rate movements and how they affect MLPs.

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