Why the current capital markets environment is positive for MLP growth
Master limited partnerships or “MLPs” are specially structured entities that must pay out most of the cash they generate to unitholders. Therefore, MLPs are especially reliant on external funding sources (as opposed to internally generated cash) to execute growth projects and acquisitions. Because of this, the state of the capital markets (generally referring to the equity and bond/loan markets) is an important factor in determining whether an MLP can find the money to participate in growth oriented activities.
Broadly speaking, the cost of debt (the rate of interest for borrowing money) for MLPs is the lowest it has been for several years. This is largely due to two reasons: (1) the Federal Reserve, through quantitative easing, has executed a low interest rate policy which has lowered rates for borrowers throughout the financial system and (2) in the period following the extreme market turbulence of 2008, most security prices rallied as investors became more comfortable taking on risk again.
For example, the chart below displays the yield on Enterprise Products’ (EPD) 5.25% Notes due 2020 (in plain terms, a bond with a 5.25% coupon that matures in 2020), in addition to Enbridge Energy’s (EEP) 9.875% Notes due 2019, and Kinder Morgan Energy Partners’ (KMP) 6.85% Notes due 2020. Over the past several years, the yield has decreased, which means that investors have required less and less return to lend money to the same companies. Note that yields can also decrease because an individual issuer has improved in credit quality, which is possible through stronger earnings visibility, increasing cash flows, or deleveraging. In the past several years, yields have generally decreased throughout the entire MLP sector, so while these bonds may have experienced lower yields due to individual company performance, a large part of this trend is also attributable to macro factors.
Additionally, the cost of equity (or amount of return stockholders demand) has also decreased over the past few years in the MLP space. The first graph above shows the dividend yields of EPD, EEP, and KMP.
The dividend yields have contracted over the past few years, close to pre-2008 levels, showing that stockholders are requiring less and less return from holding MLPs. Therefore, current cost of debt and equity are close to the lowest levels for MLPs that they have ever been over the past several years. This is a positive for MLP growth because generally speaking, the lower the cost of funds, the more projects a company may find attractive. For example, if a company has identified a project that has returns of 15% and the company’s cost of funds is 10%, the project may be pursued. If the cost of funds increases, for example to 20%, the same project may no longer be viable to the company. Usually, the more attractive projects a company is able to pursue and fund, the greater the likelihood for an increase in a company’s assets and cash flow.
Currently, the capital markets are positioned to help fund MLPs’ growth, and this is constructive for the majority of MLP names such as Kinder Morgan Energy Partners (KMP), Enterprise Product Partners (EPD), Plains All American Pipeline (PAA), and MarkWest Energy (MWE). Additionally, investors can gain exposure to MLPs through the Alerian MLP ETF (AMLP), an ETF which tracks a cap-weighted index comprising 50 energy MLPs.
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