Investors who have been relying on high-yield assets to generate some extra cash should lean toward master limited partnerships and related exchange traded funds in a rising rate environment.
Mark Litzerman, co-head of Real Asset Strategy at Wells Fargo, pointed out that MLPs outperform other high-yield assets like real estate investment trusts and utilities in a rising interest rate environment, reports Amey Stone for Barron’s.
Nevertheless, MLP options like JPMorgan Alerian MLP Index ETN (NYSEArca: AMJ) and Alerian MLP ETF (NYSEArca: AMLP) are not entirely free of rate risks as the companies need to rely on debt financing fore new projects, so higher rates translates to greater costs. The two ETFs still pulled back as benchmark 10-year Treasury yields rose off its February low.
“If interest rates rise again, the cost of capital for MLPs would increase, which could result in lower distributions,” according to Morningstar analyst Abby Woodham. “MLPs have historically struggled during rising rate markets, but not to the extent of other rate-sensitive investments like REITs or high-yield fixed income. During the bond sell-off of 2013, MLPs dipped but quickly recovered and went on to post strong returns for the year to date through the end of the year and for 2014 through the end of the second quarter.”
Additionally, Litzerman argues that diversified midstream partnerships could continue to grow as the U.S. energy boom is still ongoing, despite the plunge in prices.
Even though the U.S. oil rig count fell to 922 in early March from a peak of about 1,609 back in October, oil production has increased to 9.4 million barrels per day, a 40-year high, Bloomberg reports.
Investors should understand that MLPs don’t make their money based on oil or gas prices. Unlike other energy sector stocks, MLPs primarily deal with the distribution and storage of energy products, so their business model is less reliant on the commodities market since MLPs profit off the quantity of oil and natural gas they are able to move around. Consequently, MLPs act more like energy toll roads. MLPs also operate under very long-term contracts, so any temporary short-term changes in oil or gas typically have little to no effect on revenue streams. [Getting it Wrong With MLP ETFs]
Consequently, with oil production on the rise, MLPs could continue to generate greater revenue growth and more dividends for investors. AMJ has a 3.93% 12-month yield and AMLP shows a 6.72% 12-month yield. [How MLP ETFs Work]
“We continue to favor large, diversified, fee-based midstream MLPs with limited commodity exposure,” Litzermand said. “The reliable distributions of these investment-grade partnerships are expected to continue to grow, even at current energy prices.”
For more information on master limited partnerships, visit our MLPs category.