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Why the Fed’s tapering announcement affects MLPs

Ingrid Pan, CFA

Risk-free rates should theoretically affect required returns 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.

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.

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 (including MLPs) and poured it into cash and Treasuries, MLP yields have often moved in the same direction as Treasury yields.

The market reacted positively to news of the Fed’s gradual tapering

The Federal Reserve has signaled for a while that it would begin to dial back its program of purchasing certain fixed income assets in the open market, which has helped to keep interest rates down. The Fed stated that starting in January, it would reduce its purchase of Treasury bonds from $45 billion per month to $40 billion per month and its purchase of mortgage-backed securities from $40 billion per month to $35 billion per month—or a total reduction of $10 billion monthly.

The market reacted positively to the news. The Fed had been signaling at “tapering” or the reduction of these open market purchases for months, but the market had been wondering to what degree. The latest statement from the Fed showed that moves to reduce open market purchases of securities would come gradually and only on continued news of growing strength in the U.S. economy, which was positive for the markets. Plus, the official Fed language stated, “The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.” The current Fed funds rate is 0.25%, with the near zero target.

The rate on the ten-year Treasury moved up by a modest 5 basis points, from 2.84% to 2.89%. With the Fed’s latest statement, it appears that interest rates will remain very low into the near future. This is a positive for the MLP sector, which can be sensitive to rates.

Major MLP names include Kinder Morgan Energy Partners (KMP), Enterprise Products Partners (EPD), Magellan Midstream Partners (MMP), and Energy Transfer Partners (ETP). MLP ETFs such as the Alerian MLP ETF (AMLP) may also be prone to volatility in interest rates.

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