Master limited partnerships (MLPs) are often compared to other yield vehicles
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. Currently, the Alerian MLP Index, a capitalization-weighted composite of 50 energy MLPs, is trading 191 basis points (or 1.91%) wide of the Bank of America Merrill Lynch (BofAML) BBB corporate credit index (an index meant to represent the universe of bonds that are rated BBB). Note that there’s an ETF (exchange-traded fund) that tracks the Alerian MLP Index, called the Alerian MLP ETF (AMLP). The chart above shows the historic yields of the two indices.
Wider yield on Alerian MLP Index (AMLP)
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. The spread between the AMLP and BBB corporate credit indices tightened by 27 basis points for the week ended June 21, though the spread remains wide relative to historical levels.
One reason for this difference 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, 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.
Some market participants have speculated that since corporate rates have been near historic lows and will eventually increase, now could be an could be an opportune moment to rotate into equities and out of corporate debt if you have a long-term holding period—especially as equity has upside potential from growth that debt doesn’t. In this kind of environment, MLPs such as the Kinder Morgan Energy Partners (KMP), Enterprise Products Partners (EPD), Targa Resources (NGLS), and MarkWest Energy (MWE) may outperform BBB corporate credit.
The gap narrows in the shorter term yet remains historically wide
From a shorter-term perspective, the yield on the BBB BofAML Corporate Credit Index increased by 40 basis points last week, while the yield on the Alerian MLP Index increased by 13 basis points. These market movements have caused the gap between the two classes to narrow slightly, though the spread remains wide compared to historical levels.
Note that most market participants expect corporate credit rates to remain relatively low in the near future, which could play out into a persistently wide spread as long as rates remain low. Investors considering playing the spread between corporate credit and MLPs should therefore consider their individual holding periods and the difference in expectations across different time horizons for this particular strategy.
© 2013 Market Realist, Inc.