MLPs yield headaches for advisers who bought them for income

Energy-infrastructure partnerships, which had been a successful approach for advisers to deliver rich yields to income-starved clients with fewer tax consequences, have decidedly fallen into what some call a bear market.
Despite yields often exceeding 6%, the energy limited partnership category tracked by Morningstar Inc. is off 15.4% over the year ended Tuesday.
Some analysts view the performance as the chickens coming home to roost.
“What we suggest to people is that you look for income, but you do not stretch for income,” said Richard Bernstein, chief executive officer of Richard Bernstein Advisors, a firm that focuses on income-oriented investment strategies other than MLPs. Master-limited partnerships largely include publicly traded energy-infrastructure companies whose owners receive some favorable tax treatment. They can be held by individuals or funds.
Mr. Bernstein said a heavy implicit sector bet on energy could be hurting investors.
“The more that you’re deviating from the market yield, you’re taking on additional risk,” he said. “There is no free lunch.”
For Mr. Bernstein, a key indicator can be found on the firms’ earnings statements. The average oil-and-gas midstream company listed in the U.S., an important component of the investible universe for MLPs, has a negative total free cash-flow yield for the last 12 months, according to data compiled by Morningstar. That’s a measure of the money those partnerships have left over after they make investments in their business, and an indicator of what little cash remains for unitholders, as MLP owners are called.
‘BEYOND ME’
“Why someone would invest in an income investment that has a negative cash-flow yield is beyond me,” said Mr. Bernstein, formerly the chief investment strategist of Merrill Lynch & Co. Inc. “If the average financial adviser is not aware that the industry is free cash-flow negative, I think they have to do some looking at the portfolio. Some serious reevaluation of risk [is necessary].”
Another factor is a high-yield bond market that may be pricing in the risk of defaults in the energy sector as oil prices have fallen.
“Clearly, the recent performance of this asset class has been sloppy, testing the patience of investors,” Mark Litzerman, an investment strategist at the adviser-serving Wells Fargo Investment Institute, said in a note last Wednesday.
Those investors have made the asset class a draw even in a market that’s looking bearish. Some $10.5 billion moved into open-end mutual funds and ETFs in Morningstar’s energy limited partnership category over the last year — a figure putting it among the top fundraising categories of those products. That doesn’t include closed-end funds or the securities themselves, which can be traded on exchanges.
TOO MUCH CAPITAL, TOO FEW IDEAS
“Because of the surge in interest in MLPs and in energy-related investments, the cost of capital to the companies has dropped quite substantially and therefore they’ve expanded like crazy,” said Mr. Bernstein. “The amount of capital flowing into the ideas is going up, and you’re going to have too much capital chasing too few ideas.”
Kyri Loupis disagrees. The MLP specialist and portfolio manager at Goldman Sachs Asset Management, a former energy analysts at Lehman Brothers, said inflows into the market are no longer enough to support demand for capital. And he said a recent selloff has been driven more by “technical” factors, including sellers and short-sellers of exchange-traded funds and notes.
“It’s been a painful few months quite honestly,” said Mr. Loupis, a manager of the Goldman Sachs MLP Energy Infrastructure Fund (GLPAX), whose institutional share class has returned negative 10.3% this year, putting it in the 84th percentile among funds ranked in the same category by Morningstar. Mr. Loupis credits some of that to comparisons against funds whose legal structure helps their tax accounting more in down markets.
“We’re a victim of our own success,” he said. “We grew the sector too much.”
Back in 2013, Mr. Loupis said the partnerships were under-owned.
Still, he and a number of investors are now making the case for sticking with the asset class, despite tightening monetary policy that will raise borrowing costs for an industry heavily dependent on making investments in oil-and-gas distribution infrastructure at the right cost.
“In a world where pretty much every other asset is at an all-time high,” he said, MLPs are valued relatively cheaply.
Among the bulls’ points, the revenue in the partnerships — often derived from heavily regulated contracts negotiated in advance with energy producers — may matter much more than borrowing costs. And the increasing dominance of the U.S. in producing natural gas and oil — including from shale formations such as the Bakken formation in and around North Dakota — may mean long, continued demand for distribution infrastructure.
ALTERNATIVE METRICS
Mr. Litzerman proposes alternative metrics for investors to examine other than cash flow. One is the industry’s potentially healthy levels of production and capital expenditures, a kind of long-term investment in the business.
Another metric is the spread, or difference, between distribution yields of MLPs in the Alerian MLP Index and those offered by the Barclays Baa Municipal Index, a collection of low-credit municipal bonds that, like MLPs, enjoy favorable tax treatment. Mr. Litzerman said the fact that this spread is almost as large as it has been over the last five years indicates that those MLP yields are relatively attractive.
“The relatively high-distribution yields available from MLPs have been one of the primary attractions for individual investors seeking higher income,” he said. “Although they are not tax-exempt, they are tax-deferred, being treated as a return of capital. As such, many investors are likely to compare the distribution yield available to the yield on municipal bonds.”
However, he conceded that the history of many MLP investments are limited, “making it difficult to draw historical comparisons.”
“The recent selloff for them has mostly been due to energy prices and oil,” said Matt Cody, chair of the asset allocation committee at Wetherby Asset Management, whose firm has been weighing increasing its allocation to the investments. “You see the market trade periodically on what energy prices are doing, but over time people tend to realize that their funds are necessarily linked with oil prices.
“As long as there’s still demand, they’re going to do fine, and they’re not really affected by over-supply,” he said.

Related Topics: Goldman Sachs & Co., Merrill Lynch, Morningstar Inc.