Risk-Adjusted MLPs Look Good

With yields on treasury instruments are at all-time lows (the 10-year yield is hovering around the 50-year low of ~2.5%), to say that these are extraordinary times would be an understatement. The severe compression in treasury yields (the 3-month paper is yielding close to zero, even briefly slipping into the negative territory) reflects extreme risk aversion. This 'flight to safety' has starved many otherwise stable sectors of capital, pushing risk premiums into irrational territories.

One such sector hit unnecessarily hard by the current downturn is the publicly traded master limited partnerships group (MLPs), particularly those owning and operating energy infrastructure assets. The assets that these partnerships own -- oil and natural gas pipelines and storage facilities -- typically bring in stable fee-based revenues and have limited, if any, direct commodity-price exposure. This enables these MLPs to pay out fairly growing distributions (dividends).

Granted, weak demand for oil and natural gas impacts pipeline volumes and reduced access to credit/equity markets affects growth plans, but the extent of the sell-off in the group is much greater than can be justified by fundamentals alone.

This atmosphere of fear and over-reaction has created attractive opportunities to own quality energy infrastructure MLPs with low risk profiles and juicy yields.

• While MLPs no doubt have significant ongoing need for outside capital (debt as well as equity), they do not need funding for ongoing operations or to maintain their distributions. MLPs are mandated by law to pay out substantially all of their cash flows to unitholders after meeting their operating, maintenance capex and debt obligations. As such, they are constrained to access outside markets to fund ONLY their growth initiatives.
• So while access to the credit and equity markets is the only way for MLPs to fund growth projects or acquisitions, lack of the same would basically have an impact on growth. They will continue to operate and pay out distributions. Most of them will even be able to grow distributions, albeit at a slower rate.
• They extent of the recent MLP sell-off appears to suggest that distributions are in danger; nothing could be farther from the truth. Most of the MLPs in our coverage universe can not only easily maintain distributions at current levels, but actually grow them.

We have all along advocated the group as a high-yield diversification play (very low betas) that needed to be considered in any diversified portfolio. But while MLPs' diversification attributes have been tarnished to some extent by their recent correlated move with the rest of the equity markets, they are more than offset by group's extremely compelling valuation.

The level of yield spread to the 10-year Treasury bond, our preferred MLP valuation metric, is at an all-time high right now. The average yield for our MLP universe is 11.4%, which represents an 876 basis-point spread over the 10-year Treasury. Just to put the current spread level in a historical context, it was at 388 basis points in late July 2008 and 184 basis points in January 2007. Historically, the spread has remained under 200 basis points.

Our Buy-rated names -- Enterprise (EPD - Analyst Report), NuStar (NS - Snapshot Report), Energy Transfer (ETP - Analyst Report), TC PipeLines (TCLP - Analyst Report), and now Kinder Morgan (KMP - Analyst Report) are investment-grade credits with comfortable distribution coverage levels. We believe that these entities offer some of the best risk-adjusted yields in the current market.

Read the full analyst report on EPD

Read the full analyst report on NS

Read the full analyst report on ETP

Read the full analyst report on TCLP

Read the full analyst report on KMP