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Relative value trade between MLP yields and corporate credit looks less attractive now

2013.07.07 - AMLP vs BBBEnlarge Graph

  • Master limited partnerships are often compared to other yield vehicles such as corporate bonds due to their distribution feature.
  • The yield on the Alerian MLP Index ETF (AMLP) is currently significantly wider than the yield on the BBB corporate credit index, and also wider than the 10 year average spread between the two indices. Because of the wider than historical spread, some market participants may view MLPs as relatively undervalued in comparison to BBB corporate credit.
  • However, recently the spread has between the AMLP and BBB corporate credit index has tightened significantly. The spread tightened by 22 bps for the week ended June 28, and by 64 bps during the month of June.  

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 master limited partnerships, is trading 169 basis points (or 1.69%) wide of the BofAML BBB corporate credit index (an index which is meant to represent the universe of bonds that are rated BBB). Note that there is an ETF which tracks the Alerian MLP Index which is called the Alerian MLP ETF (AMLP). The top chart shows the historic yields of the two indices. Additionally, as seen in the below chart, the difference in yields between MLPs and corporate credit is wider than the 10-year average spread, though this gap has closed dramatically in the past two months. During this period, corporate borrowing rates spiked as the market anticipated the Fed would end its stimulus measures and rates increased across the board.

2013.07.07 - AMLP vs BBB vs avg vs 3Enlarge Graph

One reason for that corporate credit had been trading at such low yields prior to 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 had 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 had speculated that since corporate rates were near historic lows and would eventually increase, that it could be an could be an opportune moment to rotate into equities and out of corporate debt if one has a long term holding period, especially as equity has upside potential from growth that debt does not. In such an 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. Some of this trade has already played out over the past two months.

From a shorter term perspective, the yield on the BBB BofAML Corporate Credit Index decreased by 1 bps last week, while the yield on the Alerian MLP Index increased by 23 bps. Though the spread remains wide to historical levels, recently the spread has closed in significantly which reduces the relative value opportunity between the two asset classes. 

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