Master limited partnerships (MLP) are becoming more interesting to investors seeking higher returns than current bond yields, but without the changes in value that stocks can experience.

An MLP is a limited partnership that meets a number of legal tests, but for practical purposes it is like a real estate limited partnership with public stock, except that instead of owning real estate the majority are “energy MLPs” that own pipelines for gasoline, oil or natural gas. These companies lease the pipelines under long-term contracts and receive rental income, substantially all of which is distributed to the shareholders (after expenses).

The main risks in investing in MLPs has to do with the demand for oil and natural gas. Since the fees charged to transport the products are not based on the price of the commodity, the investor is somewhat sheltered from price fluctuation. But since the fees are based on the amount of product transported, if there is a slowdown in the amount of product to be transported, distributions could go down.

In addition to the higher yields provided by energy MLPs, in some cases there are tax advantages. Often the yields are classified as a return of capital, and thus are not taxable when received. As your cost basis is reduced from the return of capital it increases the tax when you sell your shares, but this tax might be at capital gain rates, thus in some sense you have transferred ordinary income into capital gains. On the other hand, those distributions not classified as a return of capital are ordinary income and do not receive the favorable dividend treatment.

Also, some MLPs require more extensive reporting of K-1s in each state in which the MLP operates, which can cost a bit more in tax preparer fees each year. This disadvantage has been cured by the rise in energy ETFs, which have different tax reporting requirements.

One advantage of most MLPs that investors don’t often think about is the management fee structure. Yes, management fees are a drawback, but because of the legal rules of MLPs the typical MLP contract ties the management fees to distributions. That means that the managers are motivated to distribute as much as possible to earn more for themselves. That seems just the opposite of many large corporations, in which the officers are motivated not to pay out dividends so they can pay out more in salaries to themselves.

The hot new area of MLPs are funds and ETFs that combine a number of MLPs into one company for diversification, and for simplicity of tax reporting.

According to Wikipedia, in May 2010, the first ever MLP mutual fund was launched, with a stated goal of providing “a high level of inflation-protected income currently through a 7.8 percent distribution yield, which is higher than equity alternatives such as REITs and Utilities.” The fund is a part of the SteelPath Mutual Fund Family (now OppenheimerFunds).

On Aug. 25, 2010, the first MLP exchange traded fund (ETF) was launched by Alerian, the company that manages the benchmark MLP index (NYSE: ^AMZ). This fund was similarly designed to the above mentioned mutual fund in that it avails a new level of diversification to investors and, according to Alerian President Kenny Feng, “provides a single Form 1099, no K-1s, and allows investors to potentially benefit from return of capital and qualified dividend tax treatment of distributions.” The fund is known as the Alerian MLP ETF (NYSE: AMLP).

Since that time a number of IPOs have also come online that are not ETFs or funds. One such is USA Compression Partners (USAC), which priced 11 million shares at $18, projected to produce a yield of about 9 percent at opening. The company provides natural gas compression services, so it might not have the stability of some Energy MLPs. But since going public, the stock has risen from $18 to almost $20, and, according to the company, revenues have gone up about 20 percent during the past quarter.

A drawback in reviewing financial information about MLPs is that the information is hard to understand, partly because of the classification of the returns mainly as a return of capital. But one negative does stand out: the bid and ask prices have substantial disparity. That means that the price you can buy it at is $1 or more above the price you can sell it at. So it’s a bit like the real estate brokers’ commission you pay when you sell a house: when you buy the house you already know that you are going to lose about 5 percent of the value when you go to sell it.

A number of oil related ETFs have opened up, and the returns on them have been very good indeed.  My experience has been that ETFs that “leverage” by going up or down two or three times the actual change in price are not a very good investment, so I would stay clear of those.

But for an investment to produce an above average yield during the rest of 2013, when it appears that interest rates will not move up very much, and oil will still be a valuable commodity, I think energy ETFs are a good way to go.

One strategy that has been suggested to me, but I have not yet tried, is to “collar” a high yield ETF that has options to get a high yield with little or no risk. In this strategy you buy an ETF or just stock in an energy MLP, and buy a put at a price just below the price of the stock as insurance against a decline in the price. To pay the premium for the put (the “insurance”) you sell a call just above the price of the stock, and in effect give away any upside in the investment since you are buying it for the yield, not for the upside.

On the surface this seems pretty foolproof, but before trying it I would want to look carefully at the decline in price as substantial distributions are paid out as return of capital. It might be that just as you start to really get a good return on the investment it gets called away by the lessor fool.

 

For information about Merv Hecht and more details on the strategies and stocks he writes about in this column, visit his website at DoubleYourYield.com.