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Why investors could find MLPs more attractive than credit

Ingrid Pan, CFA

Master limited partnership yields are often benchmarked against corporate credit yields

The relative value of master limited partnerships (MLPs) is often compared to other yield vehicles, such as corporate bonds. This is because MLPs pay out a quarterly distribution, and one of the main investment points of MLPs is the income generated from owning them. The Alerian MLP Index, a capitalization-weighted composite of 50 energy master limited partnerships, was trading 198 basis points (or 1.98%) wide of the BofAML (Bank of America Merrill Lynch) BBB corporate credit index on August 9. This index represents the universe of bonds that are rated BBB. The spread between the two widened 8 basis points from the end of July, when it was at 190 basis points, which slightly increases the disparity between the two and makes favoring MLPs over debt more attractive.

(Read more: Why MLPs provide excellent risk-reward for investors)

Note that there’s an ETF that tracks the Alerian MLP Index, called the Alerian MLP ETF (AMLP). The chart above shows the historic yields of the two indices. Plus, as you can see in the following chart, the difference in yields between MLPs and corporate credit is significantly wider than the ten-year average spread.

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Fed stimulus had depressed rates on corporate credit, but yields are expected to rise

One reason for this is that the Federal Reserve pumped money through the financial system in an effort to keep lending rates low, and many investors looking for yield have put their dollars to work in corporate credits, driving yields lower and lower. Demand for corporate credit had left other yield asset classes, such as MLPs, looking relatively undervalued. However, investors should note that despite the yield aspect of MLPs, they are indeed equities, which are inherently more volatile than debt.

As the U.S. economy improves, the market expects the Fed to put an end to “easy money,” and rates on fixed income across the spectrum—from Treasuries to high yield debt—have increased. This has closed some of the gap between the yields on corporate credit and MLPs. If rates on debt rise further, the gap could continue to close in. This could provide an opportune moment to rotate into equities and out of corporate debt.

In this type of environment, MLPs such as Kinder Morgan Energy Partners (KMP), Enterprise Products Partners (EPD), Targa Resources (NGLS), and MarkWest Energy (MWE), or a fund such as the Alerian MLP ETF (AMLP) could be more attractive than corporate credit, and these investments still provide current income through distributions.

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

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