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Risk-free rates should theoretically affect the required return on master limited partnerships
Investors who hold master limited partnership (MLP) stocks often monitor interest rates on Treasury bonds. This is because many investors hold MLP stocks for the distribution or “yield” component of the securities. U.S. government Treasury yields are relevant because if rates on the bonds increase, investors should expect rates on MLPs to theoretically increase as well. This is because many view U.S. Treasuries as one of the safest yielding investments in the financial universe, and if the rates on Treasuries increase, the yield required from MLPs (and all other yield instruments) should also theoretically increase. When the yield on MLPs increases, the price and valuation of MLPs decrease.
Lower Treasury rates also push investors to “hunt for yield”
Additionally, when yields on instruments such as Treasuries decrease, it also pushes investors seeking current income into other instruments such as corporate bonds and MLPs. Therefore, as Treasury yields decrease, yields across the bond sector and higher dividend stocks such as MLPs also tend to decrease.
Rates on ten-year Treasury continued to surge up
The yield on the benchmark ten-year Treasury increased sharply last week, rising from 2.49% to 2.74% for the week ended July 5. The yield on the ten-year Treasury has been consistently on the rise since early May, when it was trading at around 1.65% compared to current levels of ~2.70%. The rate on the ten-year Treasury is the highest it has been since mid 2011.
But the rates remain relatively low from a long-term perspective
In the context of a longer time period, Treasury yields had been close to all-time lows for a while. But recently, yields have backed up significantly. The graph below shows historic yields on the ten-year Treasury from the beginning of 2001 to present.
The low yields over the past few years mostly affect the Federal Reserve pumping money and liquidity into the financial system. However, in June, Fed Chairman Ben Bernanke commented that the Fed’s stimulus program could end as strength returns to the economy. The markets had reacted negatively to those comments, but there have been further comments from the Fed that curtailments to stimulus measures would likely not come in the short term and we would have to see improved employment figures. The graph below shows the yields on the Alerian MLP Index versus ten-year Treasury yields.
Historically, MLP yields have moved with Treasury yields
Except for the period of the financial crisis, where investors pulled money out of riskier investments such as equities (including MLPs) and poured it into cash and Treasuries, MLP yields have often moved in tandem with Treasury yields.
Last week, the yield on the ten-year Treasury increased, which was a negative for MLPs
Furthermore, over the past several weeks, the yields on Treasury instruments increased to the highest points in over a year, which was a negative medium-term catalyst for the rate-sensitive MLP sector. Lastly, from a longer-term perspective, rates remain relatively low, which has resulted in a long-term positive for MLPs. If rates eventually rise, for example, to pre-recession levels of 4% to 5%, the increase could be a negative for MLPs and the Alerian MLP Index (AMLP). Major names in the index include Enterprise Products Partners (EPD), Kinder Morgan Energy Partners (KMP), Magellan Midstream Partners (MMP), and Plains All American Pipeline (PAA). So owners of MLPs should be aware of rate movements and how they affect MLPs.
© 2013 Market Realist, Inc.