Must-know: 1 important way Fed tapering affects MLPs

2 key things MLP investors watch to keep track of interest rates

Gauging interest rates

There are a few benchmarks that investors watch to gauge where rates are. The first is the ten-year Treasury, which is debt issued by the U.S. government. Investors watch the ten-year note as a benchmark for the “risk-free” rate, as conventionally, U.S. government debt has been regarded as a “risk-free” investment. To give some context, the ten-year Treasury has been at historic lows through much of 2012 and 2013, with yields below 2%. However, since mid-2013, rates on the note have crept up to yield ~2.5-3.0%. This has been mainly due to “tapering” from the Federal Reserve, through which the Fed scales back its purchases of certain bonds in the open market, which had been acting to keep rates low.

2014.02.25 - GT10 LTEnlarge Graph

Another measure that investors watch is the yield on corporate credit. Corporate credit represents the rates at which companies can borrow (as opposed to the U.S. government). Generally, corporate credit trades at higher yields than Treasurys, as there’s more risk (for example, a company could go bankrupt and not be able to pay off its debt). The more perceived risk there is with a company, the higher the yield should be. One way to monitor corporate credit yields is through a credit index such as the BofA Merrill Lynch indices. For example, BofA Merrill Lynch publishes information on an index of BBB rated debt. The index tracks different parameters on the universe of BBB rated corporate bonds. Alongside Treasurys, yields on this index were at their lowest points in late 2012 and early 2013. Again, as investors anticipated Fed tapering, yields rose to above 4% at some points in late 2013 and the index currently yields ~3.6%. The direction in which this index moves gives at least a rough indicator as to whether debt funding is getting cheaper or more expensive for companies.

2014.02.25 - BBB STEnlarge Graph

While rates have risen since mid-2013, they haven’t increased by that much from a long-term context. During the recessionary period of late 2008 and 2009, the yield on the BBB index spiked to over 9% at points, reflecting investors’ fear and hesitation to invest in companies. Plus, the ten-year average on the index’s yield is ~$5.4, compared to the current yield of 3.6%. So while funding may be getting more expensive, it currently isn’t a material headwind and likely only has a minimal effect on MLPs’ consideration to pursue and finance certain projects—at least for now.

However, note that a material spike in rates could definitely affect MLPs such as Kinder Morgan Energy Partners (KMP), Enterprise Products Partners (EPD), MarkWest Energy Partners (MWE), and DCP Midstream Partners (DPM) as well as MLP ETFs such as the Alerian MLP ETF (AMLP). So Market Realist will periodically publish articles with the details of certain benchmark rates.

To learn more about investing in MLPs, see the Market Realist series Important drivers behind the drop in Boardwalk’s stock price.