With yields on both the S&P 500 and long-term Treasuries maxing out at around 2%, investors continue their difficult searches for higher levels of income in their portfolios. Stacey Morris, CFA is the Director of Research at Alerian and joined the ETF Think Tank to talk about the current state of the MLP space and how their high yields could fit into a portfolio.
Morris notes that there are positive fundamental shifts taking place in the industry. The COVID pandemic resulted in a lot of distribution cuts during the first half, but many MLPs used the opportunity to clean up their financial conditions. There has been a focus on debt reduction, financial flexibility and distribution sustainability. MLPs used to be prolific equity issuers in order to raise the necessary capital to build out pipelines and infrastructure, but many have moved away from that. The focus is more on retaining cash flow and self-funding. Many are now buying back equity instead of issuing it.
While the midstream space is dominated by MLPs, the composition has changed over time. Some have been taken private, some have consolidated with others, and some have entered as C-corps instead of MLPs. Traditional MLPs have fallen from 60% to about 38% of the total universe. The 2017 tax reform package essentially maintained the MLP tax advantage over C-corps, but that’s not what has driven the consolidation in this space. It’s been centered around structure and simplification.
Morris is asked how MLPs fit into a portfolio and how they should be categorized. She finds that many allocate to it within an income portfolio, but in generally small percentages because the high yields can quickly impact overall portfolio yield. One of the bigger benefits of MLPs is as a portfolio diversifier since they’ve historically had low correlations to utilities and Treasuries. Since MLPs don’t appear in broad market indexes, they must be added separately. Some investors categorize MLPs as real assets or alternatives. Some dump it into the energy sector, but Morris hasn’t seen it categorized as a thematic allocation.
Looking forward, MLPs could be well-positioned for where the economy may be headed, particularly with respect to inflation. Around 90% of MLP contracts have inflation escalators and mechanisms built in. The energy sector, in general, tends to do well and this has been the case in 2020.
For anyone considering adding MLPs to a portfolio, there are a number of tax considerations to be aware of. Morris explains that not only does the Alerian MLP index currently yield 7.5%, but it’s also a tax-advantaged yield. The tax properties can be complex and that may result in advisors being hesitant to use them for clients. For investors, an MLP ETF tends to be a better fit than buying MLPs directly. If you invest directly in an MLP, you’re getting a K-1, which can add complexity. Through an ETF or ETN, you’re getting the more standard 1099.
Other key takeaways:
- The infrastructure bill that just made its way through Congress won’t really have much of an impact on the MLP space. The reconciliation bill could have more consequences around carbon capture and hydrogen. One provision being discussed was extending the MLP structure to renewables, but Morris isn’t sure if that will make it in.
- The overall income outlook for MLPs has improved. Within the Alerian MLP index, Morris says that 43% of the index has raised payments, while 13% have reduced. There are plenty of growth opportunities and several have recently raised their forecasts. Free cash flows are attractive right now in addition to the high dividend yields. 70% of components have buyback programs.
- Innovation could be a key development in this space with particular opportunities existing in emissions, energy efficiency and energy transition. A lot of technology still needs to happen in hydrogen to make it more mainstream. The shift to environmentally friendly energy is a big theme.
We hope everyone in the US enjoys their Thanksgiving this week, and we will see you in December!
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