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Why debt is now a less attractive financing source for master limited partnerships

2013.07.12 - MLP Bond Yields HGEnlarge GraphMaster limited partnerships rely highly on external capital to fund growth

Master limited partnerships or MLPs are specially structured entities that must pay out most of the cash they generate to unitholders. So MLPs rely especially on external funding sources (as opposed to internally generated cash) to execute growth projects and acquisitions. Because of this reliance, the state of the capital markets (which generally refer to the equity and bond or loan markets) is an important factor in determining whether an MLP can find the money to participate in growth-oriented activities.

Debt yields have broadly spiked in June

In June, the cost of debt across most of the MLP spectrum increased significantly, a contrast from the year-to-date trend through the beginning of May, where rates decreased. For example, in the large cap space, Enterprise Products Partners (EPD) 5.25% Notes due 2020 were yielding roughly 2.8% at the end of May, compared to ~3.3% at the end of June. The yield on Plains All American Pipeline’s (PAA) 5% Notes due 2021 was ~2.8% at the end of May, compared to ~3.5% at the end of June. The yield on Kinder Morgan Energy Partners (KMP) 6.85% Notes due 2020 was ~2.9% at the end of May, compared to ~3.6% at the end of June. These larger cap names are also all investment-grade (BBB credit rating or higher), and investment-grade bonds tend to trade off Treasury movements. The ten-year benchmark Treasury yielded ~2.1% at the end of May, compared to ~2.5% at the end of June, so it’s not surprising that the yields on these investment-grade bonds were up.

2013.07.12 - MLP Bond Yields HYEnlarge Graph

Additionally, the cost of debt for small- and mid-cap MLPs also increased over the past two weeks. For example, the yield on Targa Resources Partners (NGLS) 6.875% Notes due 2021 was ~4.7% at the end of May, compared to ~5.4% at the end of June. The yield on Genesis Energy’s (GEL) 7.875% Notes due 2018 was ~4.9% at the end of May, compared to ~5.5% at the end of June. The yield on MarkWest Energy’s (MWE) 6.75% Notes due 2020 was ~4.0% at the end of May, compared to ~5.5% at the end of June.

Ending of Federal Reserve stimulus measures could cause further rate increases

Investors should note that one reason for the low rates over the past few years has been the Federal Reserve’s stimulus measures, which have lowered interest rates across the board. The Fed has stated that it would seek to end these measures once the U.S. economy gained enough strength. When this happens, interest rates could further increase. Already, a large reason why rates have increased over the past few months is because the market has started to anticipate the end of the Fed’s stimulus measures.

Over the past few weeks, the yield on MLP bonds has increased significantly, which is a negative medium-term indicator. From a longer-term perspective, the cost of debt (the rate of interest for borrowing money) for MLPs is still not prohibitively high. For further discussion on the cost of capital for MLPs, please see Why master limited partnerships up in June mean lower yields, cheaper equity capital.

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