- Master limited partnerships (MLPs) are highly dependent on external financing sources to fund growth as much of their excess cash flow is distributed to unit holders.
- The current debt capital markets environment is strong, allowing MLPs access to relatively cheap debt and equity capital, which is a positive for growth.
Master limited partnerships, or “MLPs,” are specially structured entities that must pay out most of the cash they generate to unit holders. Therefore, MLPs are especially reliant on external funding sources (as opposed to internally generated cash) to execute growth projects and acquisitions. Because of this, the state of the capital markets (generally referring to the equity and bond/loan markets) is an important factor in determining whether an MLP can find the money to participate in growth oriented activities.
Over the past two weeks, the cost of debt across most of the MLP spectrum increased slightly, 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 2.5% in mid-May, compared to ~2.3% in the beginning of May. The yield on Plains All American Pipeline’s (PAA) 5% Notes due 2021 was ~2.7% in mid-May, compared to ~2.4% at the beginning of May. The yield on Kinder Morgan Energy Partners (KMP) 6.85% Notes due 2020 was ~2.7% in mid-May, compared to ~2.4% at the beginning of May. 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 ~1.9% in mid-May, compared to ~1.7% at the beginning of May, so it is not surprising that the yields on the aforementioned investment grade bonds were up.
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 ~3.8% in mid-May, compared to ~3.6% at the beginning of May. The yield on Genesis Energy’s (GEL) 7.875% Notes due 2018 was ~4.0% in mid-May, compared to ~3.7% at the beginning of May. The yield on MarkWest Energy’s (MWE) 6.75% Notes due 2020 was ~3.6% in mid-May, compared to ~3.4% at the beginning of May. These smid cap MLPs are all high yield (non-investment grade bonds), which can be sensitive to broader interest rates. However, because they are perceived to have higher risk than investment grade bonds, high yield bonds also may rally more in a “risk-on” environment, and are more closely correlated with equity market movements than their investment grade counterparts. Equity indices performed well over the past two weeks, so it seems that high yield bonds were more affected by the movement in rates over the same period. For May 15th compared to April 30th, the S&P500 gained 3.8% and the Alerian MLP Index gained 0.9%.
Over the past two weeks, the yield on MLP bonds has increased slightly, which is a negative short-term indicator. From a longer-term perspective, the cost of debt (the rate of interest for borrowing money) for MLPs is still close to the lowest it has been for several years. This is largely due to two reasons: (1) the Federal Reserve, through quantitative easing, has executed a low interest rate policy which has lowered rates for borrowers throughout the financial system and (2) in the period following the extreme market turbulence of 2008, most security prices rallied as investors became more comfortable taking on risk again. For further discussion on cost of capital for MLPs, see MLPs continue to have access to cheap equity capital to fuel growth and Why the current capital markets environment is positive for MLP growth.