Published:
July 4, 2007
The day before Thanksgiving
in 1996, Rich Kinder left his post
at Enron. He was disappointed that
Kenneth Lay had passed him over for
the job of CEO. Soon after, an old
college buddy, Bill Morgan,
approached Kinder with a business
proposition.
Morgan had just bought some assets
that Enron had no use for -- a
couple of small pipeline systems and
a coal terminal. He needed someone
like Kinder to run the business.
Kinder agreed and the partnership
was christened Kinder Morgan Inc. in
February 1997.
Seven months later, Kinder had
doubled the company's market
capitalization to nearly half a
billion dollars by watching costs
and shipping more volume through the
pipelines. Today, Kinder Morgan
Energy Partners is a $10 billion
business, operating 25,000 miles of
pipeline and 145 terminals
throughout the U.S.
Master
limited partnerships (MLPs) had
already been around for decades, but
it took someone like Rich Kinder to
transform this asset class from a
passive holding company into a
dynamic investment vehicle.
In the mid-1990's, Kinder Morgan was
one of only about a half-dozen
master limited partnerships, which
together totaled roughly $2 billion
in market capitalization. Today,
there are over 50 actively-traded
MLPs with a total market cap of
nearly $80 billion.
What Makes MLPs so Attractive?
It may have something to do with
their enticing yields of up to 11%.
Then again, it could be their
market-beating annual returns of
+17% since 1996. Or maybe it's their
exceptional track record for raising
dividends an average of 8% to 9% a
year for the past ten years that has
endeared them to income investors.
Perhaps the best news is that the
group is still firing on all
cylinders. The benchmark Alerian MLP
Index of the 50 largest MLPs has
handily outperformed the S&P in
recent months.
Safety and Growth -- A Rare Mix
Like real estate investment trusts
(REITs), MLPs pay out most of their
cash flow to shareholders. As a
result, the group carries an average
yield of about 6.0% -- more than
three times the puny 1.6% yield
offered by the average stock in the
S&P 500 Index.
But their healthy yields aren't even
their main attraction. Rather it's
the rare mix of safety and growth
that makes MLPs a must-have asset
class for your income portfolio.
Although a variety of companies in
different industries are organized
as MLPs, energy and pipeline MLPs
are far and away the most prevalent
type. As a result, investors often
flock to MLPs when energy prices
move higher. However, the nice thing
about many MLPs is that they offer
the yield-starved investor a
steadily rising income stream no
matter which direction oil and gas
prices move.
What many people may not realize is
that commodity prices don't affect
pipeline operators' cash flows as
much as energy demand. Instead,
their profits depend on the volume
of product that gets pushed through
their pipelines and other energy
distribution systems. As long as
demand continues to grow, so will
profits.
U.S. energy demand is expected to
grow a steady +1.25% annually for
the next 20 years, just as it has
over the past 20 years. As a result,
MLPs should continue to provide a
growing income stream for years to
come.
MLPs Come In a Variety of Flavors
That said, some energy-related MLPs
deliver more predictable earnings
and dividends than others. For
example, pipeline operators like
Kinder Morgan (KMP) usually generate
stable income, but growth tends to
be constrained by government
regulation on rates. Meanwhile,
propane distributors generally offer
more upside potential than
pipelines. Their rates aren't
regulated, but warm winters or cool
summers could affect demand for
their product.
More Pipe Means More Profits
With most of the profits going to
shareholders, what will drive this
sector's growth in the months and
years ahead? Most MLPs make money by
delivering natural gas and petroleum
products to the market. The more
pipelines, gathering systems, tanks,
barges, or royalty interests they
own, the more cash flow they can
generate.
Their key to growth is buying or
building the infrastructure that
will ramp up their product capacity.
And this group has been doing just
that. The five largest MLPs will
likely spend over $13 billion on
development projects over the next
three years, according to investment
firm Wachovia.
Growing Institutional Interest
You know an industry is getting hot
when major financial institutions
start piling into it. For years,
MLPs were owned almost exclusively
by individual investors.
Institutional investors held less
than 5% of these securities.
Now that's changing, and
institutions are homing in on this
once overlooked sector. Mutual funds
were recently given the green light
to hold more MLPs in their
portfolios. In October 2004,
Congress passed a law allowing funds
to hold up to 25% of their assets in
MLPs, whereas previously MLPs could
account for no more than 10% of
their assets.
Closed-end funds have been quick to
the scene. Institutional investors
like Kayne Anderson and Fiduciary
have invested some $3 billion over
the past two years to develop
several new closed-end funds
dedicated to master limited
partnerships.
And more funds are about to come to
market. Last summer, two financial
giants, Citigroup and Alerian, each
launched their own MLP indexes.
These benchmark indexes are likely
precursors for new funds that will
be hunting for MLP investments. As
more and more institutional money
chases this small group of stocks,
the buying pressure should send
share prices higher.
Taxes are Complex but Funds Can
Help
Most MLP distributions are comprised
of about 20% net income and 80%
return of capital (which is really
just an allowance for depletion or
depreciation). The income portion is
generally taxed at your ordinary
income tax rate. You don't pay taxes
on the return of capital portion
until you sell the security, making
MLPs ideal for long-term investors.
Return of capital distributions lead
to a reduction in your cost
basis. For example, if you pay
$50 a share for an MLP and receive a
$5 return of capital distribution
this year, then the cost basis of
your shares will decline to $45. Say
you sell the shares next year at $55
a share. You will be taxed at your
ordinary income tax rate on the $10
in capital gains ($55 less $45).
There is one glitch with MLPs,
however. Individual MLPs aren't
suitable for individual retirement
or other tax-deferred accounts
because they generate a type of
income called "unrelated
business taxable income," or
UBTI. If your retirement account
earns more than $1,000 of this
income, then you'll end up paying
taxes on it. As a result, you
probably want to hold MLPs in a
taxable (regular brokerage) account.
You can skirt around the UBTI issue
by opting for a closed-end fund that
invests in MLPs. These funds handle
the complexities of K-1 tax forms,
Schedule E: Supplemental Income and
Loss, and out-of-state returns that
may need to be filed for individual
MLP securities.
Funds simply send you a 1099-Div
form to file your investment income.
The dividends you collect from these
closed-end funds are generally taxed
as ordinary income, but unlike
individual MLPs, you can hold these
funds in a tax-deferred IRA or Roth
account without incurring additional
UBTI. Although management fees take
a bite out of their yield, thanks to
their tax and diversification
benefits, MLP funds remain an
excellent choice for many investors.
Want to learn more about
master-limited partnerships, as well
as the names and ticker symbols of
some of the leading players? In a
recent issue of her High-Yield
Investing newsletter, editor
Carla Pasternak provided a
comprehensive list of 50 individual
MLPs and over a half-dozen MLP
funds. In addition, she profiled her
two favorites from these lists -- a
minerals company with an 11.2%
dividend yield and a propane
distributor with an 8.6% yield.
In addition to MLP information,
Carla also regularly profiles a host
of other income-oriented
investments, including REITs,
Canadian Trusts, and more. If you're
interested in earning steady returns
though income investing, then visit
this link to learn more about High-Yield
Investing.
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