What’s the yield spread?
The yield spread represents the difference in yield between a government bond—typically the ten-year Treasury—and the yield of a stock or asset class—like MLPs (master limited partnerships). Since a promise from the US government is considered risk-free, the spread represents the additional risk that an investor is willing to take in exchange for a higher return, or yield.
The above graph shows the yield on the Alerian MLP Index compared to the US ten-year Treasury rate. Currently, the Alerian MLP Index (AMZ) is yielding ~6% while the yield on the US ten-year Treasury is ~2%. As a result, the spread between AMZ and the ten-year Treasury yield is ~400 basis points. Technically, risky assets should have more yield than risk-free assets because investors require more return for the assumed risk.
Currently, interest rates are quite low. However, in 2007 the ten-year bonds traded at yields as high as ~5.25%. If Treasury yields spiked back up to those levels, AMZ’s yield would likely increase as well. It’s difficult to state whether the spread between the two would remain at 400 basis points.
When treasury yields rise, a MLP sponsor might face problems in raising fresh capital from debt markets for funding new projects. This may affect MLPs’ earnings growth. Also, it could result in distribution cuts. Investors usually perceive a distribution cut as a very negative event. Even a slight cut could lead to a sharp drop in MLP prices. As a result, the MLP distribution yield, or required return—calculated as distribution divided by the price—might rise.
Key ETFs and stocks
Investors can benefit from the huge yield spread by investing in MLP ETFs like the Alerian MLP ETF (AMLP). They can also buy individual MLP stocks. AMLP’s top four holdings include Enterprise Products Partners (EPD), Plains All American Pipeline LP (PAA), Magellan Midstream Partners (MMP), and Energy Transfer Partners LP (ETP).