As oil prices rebound on improved market sentiment, master limited partnership exchange traded funds have broken above their long-term trend lines and offer attractive yields to boot.
Crude oil prices just finished higher for the third consecutive week as market sentiment turned upbeat on strengthening U.S. gasoline consumption ahead of the summer driving season and signs of production dips around the world.
While MLPs are relatively insulated from oil price volatility, the extended decline in energy prices has dragged on multiple markets. Investors were worried that a traditionally attractive dividend-paying asset would no longer be able to maintain its steady payouts as U.S. oil output starts to decline after the steep drop-off in crude prices.
MLPs earn money by transporting energy or storing the products. Since revenue is based on volume, MLPs may be less sensitive to crude prices. Consequently, MLPs have historically shown a weaker correlation to energy prices over longer periods as MLPs act more like energy toll roads, profiting on the volume of oil moving through their pipelines. However, as crude oil prices fell off, investors were concerned about the energy industry’s ability to keep pumping oil, which would affect the volume of crude passing through MLPs. With oil prices rebounding, MLPs are also gaining traction.
For instance, the JPMorgan Alerian MLP Index ETN (NYSEArca: AMJ) and Alerian MLP ETF (NYSEArca: AMLP), the two largest MLP-related ETPs in the space, have been rebounding alongside oil prices, even outperforming the broader energy sector in recent months. Over the past three months, AMJ jumped 35.2% and AMLP surged 37.6%, whereas the the S&P 500 Energy Sector returned 18.3%. Both AMJ and AMLP have broken above their resistance at the 200-day simple moving average, a big support line for long-term investors.
Moreover, the MLP-related exchange traded products offer attractive income opportunities. AMJ shows a 8.28% 12-month yield and AMLP has a 10.89% 12-month yield. The robust yields may have also contributed to the recent run up in MLPs as investors turned to downtrodden areas and yield-generating assets after the Federal Reserve signaled it would keep interest rates low for longer.
However, potential investors should know that MLP exchange traded funds may act differently from MLP exchange traded notes. The main difference between MLP ETFs and MLP ETNs is the tax consequences for distributions from each investment vehicle.
Both MLP-related ETFs and ETNs follow an index comprised of MLPs. However, the ETFs are structured as C corporations, whereas ETNs are organized as an unsecured debt issued by an underwriting bank.
Since MLP ETFs are structured as a C corp., these corporations are also required to pay corporate income tax on distributions before the distributions are passed through to investors – MLP ETFs are required to pay corporate taxes or a 35% federal rate on returns. Additionally, fund investors are also taxed on the fund dividends and capital-gains distributions. Consequently, MLP ETF investors are double-taxed. While it is not an explicit cost, ETF investors would see the results of the corporate tax liabilities through wider tracking errors compared to the performance of the underlying MLPs.
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Meanwhile, ETNs, unlike ETFs, do not hold physical shares of the underlying companies of the index. ETNs are an unsecured debt security that promises to pay out the value of the index at its maturity, along with any distributions. Since the note is a debt security, it is exposed to the default risk of the underwriting bank.