Spread between MLP and corporate credit yields narrowed last week, bullish for MLPs
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 (similar to bonds). Some investors monitor the yield on the Alerian MLP Index (an index composed of 50 capitalization weighted energy MLPs) against another index such as the BofA Merrill Lynch BBB Corporate Credit Index (an index composed of corporate bonds with a BBB rating) as the two had historically traded quite closely together, however, the yields on the two have diverged which some believe could be a relative value opportunity.
As of February 1, the Alerian MLP Index was trading 254 basis points (or ~2.6%) wide of the BofAML BBB corporate credit index (an index which is meant to represent the universe of bonds that are rated BBB). The spread between the two indices narrowed on the week from 272 basis points to 254 basis points (see the graph below for the historic yields on the two indices).
The gap between the two indices closed slightly last week, however, the difference in yields between MLPs and corporate credit is still at one of its widest points in recent history. One reason for this is that the Federal Reserve has 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 has left other yield asset classes, such as MLPs, look relatively undervalued. However, investors should note that despite the yield aspect of MLPs, they are indeed equities, which are inherently more volatile than debt.
Some market participants have speculated that since corporate rates are near historic lows and cannot go much lower, that now could be an opportune moment to rotate into equities (such as MLPs). Indeed, last week corporate yields rose while MLP yields declined slightly. In an environment such as last week’s, MLPs such as the Kinder Morgan Energy Partners (KMP), Enterprise Products Partners (EPD), Targa Resources (NGLS), and MarkWest Energy (MWE) may outperform corporate credit. Additionally, investors who believe the spread between MLP yields and corporate credit yields will continue to close can long an MLP ETF such as AMLP and short a corporate bond ETF such as the SPDR Barclays High Yield ETF (JNK).
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