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MLP ETFs: Still Good for Income Investors?

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2013 was pretty volatile for interest-rate sensitive sectors like Master Limited Partnerships (MLPs) thanks to the Fed tapering talks which pushed up interest rates substantially. Despite this sluggish trend, MLPs delivered a decent performance finishing the year with  average gains of about 16%.
With the Fed finally deciding on a soft QE cut-back ($10 billion per month) from this month, investors are concerned whether MLPs will able to march ahead in 2014 or not.

The Fed chairman, Ben Bernanke also commented on December 18 that the bond buying program will be curtailed in phases in 2014 and may finally end by late 2014, if improvement in the labor market matches the regulatory body’s expectation, (read: Fed Tapers Bond Purchases: 3 ETFs in Focus on the News). Since then, the downside risk in the MLP sector has increased.

Are MLPs at Risk?

MLPs are publicly traded partnerships generally engaged in the transportation, storage, production, or mining of minerals and natural resources. MLPs often operate pipelines or similar energy infrastructures that make it an interest-rate sensitive sector.

MLPs catch investor eye as these do not pay taxes at the entity level and are thus able to pay out most of their income (more than 90%) in the form of dividends like the REIT firms.  Investors looking for higher income levels outside the traditional bond sources bet on these products (read: Boost Income and Growth with MLP ETFs).

Following the ‘Taper’ announcement, interest rates started to show an uptrend which in turn sent the bond yields higher. Though the latest U.S. job report was shockingly weak and pushed the bond yields lower instantly, this does not mean that the Fed will modify its Taper plan only on the basis of one-month data.

In fact, barring this single data, all other economic indicators are pointing to the rapid pickup in the economy which in turn indicates further taper in the course of 2014. Also, even after a downward correction due to the weak job data, yield on 10-year treasury bonds again inched up to 2.84% as of January 13, 2014. 

Quite expectedly, in a rising rate environment, MLPs fall out of favor among yield-seeking investors. Plus, if interest rates rise, MLPs will have to pay higher for the huge chunk of borrowed money which may in turn force them to lower their dividend payout ratio.  

Is there Any Hope?

Probably Yes. First of all, if at all the nominal rate starts going up, analysts believe that the rise in inflation-adjusted real rates in 2014 might be lower than last year. 

On the contrary, the Fed’s decision on further taper in 2014 will depend on whether inflation and employment perk up at a desired pace. That means that a gradual interest rate rise in a modestly inflationary environment may not prove that bad for the rate-sensitive sectors (read: REIT ETFs in Taper Aftermath: Any Hope for Gains Now?).

MLPs are relatively safe and less risky options in the broader energy space. This can be validated by the fact that when oil as commodity was weak in most of 2013 thanks to the strength in the greenback, oil producing ETFs especially those in the MLP ETF space were better placed.

Further, with consistent growth in the energy industry expected from new developments in the field of unconventional energy, energy MLP ETFs should benefit considerably over the long term. After all, rates do not always rise on tightening of monetary policy. A growing economy and increased business activities may also push the rates higher. 

ETF Impact

In such a scenario, investors might want to pay close attention to the MLP market in the near term. Below, we briefly highlight the some funds in the space which could be great picks for 2014.

Some top MLP ETFs like Alerian MLP ETF (AMLP), JP Morgan Alerian MLP Index ETN (AMJ), UBS E-TRACS Alerian MLP Infrastructure Index (MLPI) lost 0.46%, 0.31%, 0.36% in the first 10 days of January while SPDR S&P 500 (SPY) added 0.17% during the same time frame (see more ETFs in the Zacks ETF Center). One fund ETRACS Alerian MLP Index ETN (AMU) however gained 0.11% in the short period.

The return figures confirm the fact that MLPs were not severely beaten down post taper announcement. The mild losses were in line with the broader market and may be were reflections of pent-up profit booking activity. 

AMLP is an extremely popular choice in the space with more than $7 billion in assets, but funds like AMJ ($5.7 billion) and MLPI ($1.6 billion) also attract sufficient investments. Among these, AMU is a slightly overlooked option with around $200 million of assets. Investors should also note that all four funds currently have a dividend yield of more than 3% (more than the 10-year Treasury bond yield) with AMLP boasting as high as 6.09%.

Bottom Line

As the market has essentially priced in some cuts to the QE program this year,  we do not expect much disruption in the interest rate world if the Fed pairs down its stimulus gradually. Though some psychology-induced sell-offs will be there in MLPs with each Fed announcement, the inherent fundamentals of the sector should remain strong.

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