Get the Timing Right for MLP Stocks

by Zach Scheidt

Shares of MLP stocks (or master limited partnerships) can be some of the strongest dividend-paying securities available to investors. While technically not stocks (they are actually classified as "units" of a limited partnership), these securities typically feature a high level of income while also offering investors some attractive tax benefits.

Here's how the structure works:

  • MLPs are generally required to produce 90% of their income from business associated with natural resources. In practice, MLPs are most often set up for energy firms such as pipeline companies or other distribution businesses.
  • MLPs are required to pay out all earnings not needed for current operations and maintenance. Since the companies do not retain earnings for future growth, most MLPs pay a monthly or quarterly distribution that is significantly higher than dividend yields for traditional stocks.
  • MLPs are not taxed at the corporate level. These businesses are considered "partnerships" for tax purposes. This keeps company earnings from being double-taxed (at the corporate and at the personal level), leaving more capital available for investors.
  • Distributions can have significant personal tax benefits. From a tax perspective, these distributions are split into two categories. Part of the distribution is considered taxable income. But the other portion is classified as "return of capital" to shareholders and cannot be taxed.

As a general rule, I'm a big fan of these securities for investors who need to generate income in their portfolios. Not only do MLPs pay a healthy dividend yield, the tax advantages can also go a long way toward preserving your wealth.

But in today's market there is one significant risk you should be aware of - a risk that may cause you to want to wait a few months before allocating capital to this sector.

Interest Rate Concerns Trigger Capital Rotation

Recent comments from Ben Bernanke and other members of the Federal Reserve have had a significant effect on income-generating investments.

As discussed in my recent note on utilities stocks, the Fed's low interest rate policy has driven a significant amount of "safe" capital out of traditional fixed income securities such as Treasury bonds and mortgage-backed securities. With the Fed plowing $85 billion dollars a month into these assets, prices have been artificially supported and corresponding yields have been pushed to historical lows.

This has caused investors who would have bought bonds to look for other places to generate income. And many sectors such as utilities stocks and the MLP shares have benefited from this capital rotation.

But now that the Fed has begun discussing when it will "moderate" or lower its bond purchases, that rotation of capital is reversing. Over the next few months, the Fed is expected to gradually reduce its bond purchases, with a stated goal of concluding the program sometime in 2014.

Traders are already positioning themselves ahead of this shift. We have seen Treasury bond and mortgage-backed security prices drop and the yields begin to pick back up. This change in yield is sending an invitation to conservative investors to once again start allocating capital to these safe areas and away from the riskier dividend-paying stocks.

Even though many of the dividend-paying stocks (such as the MLP shares) are still great long-term investments, we can expect a significant amount of capital to rotate out of these areas.

While I'm definitely in favor of holding investment positions for long time frames (under the right circumstances), this is one of those periods where I believe we have a great opportunity to sell shares that have a strong long-term prognosis, because of near-certain weakness in the short run.

Buying these shares several months from now at discounted prices gives us two major advantages. First, we can expect to receive a higher yield percentage because we will be able to enjoy the same dividend payments while paying less for the shares. And second, we can expect a higher overall rate of return as the shares appreciate from lower levels.

Light at the End of the Tunnel

Once the rotation of capital is complete, MLP investments should continue to be excellent positions to hold. Pipeline companies in particular look very attractive because of the dramatic increase in the amount of natural gas and oil that is being produced in the United States.

Most traditional energy stocks are vulnerable right now because the U.S. is rapidly increasing the amount of oil and natural gas produced. Oil inventories are well above historical averages, which should keep a lid on prices - and may even send the price of oil significantly lower.

Exploration and production (E&P) companies could be hurt by lower oil prices. These companies have operational costs along with fixed costs paid to acquire the reserves. So if their selling price for the oil they produce drops, profits will naturally contract alongside.

But pipeline companies don't typically make money based on the price of oil or natural gas. Instead, they generate income based on the volume of product that is being transported, along with the distance the product travels.

With oil and gas companies rapidly expanding their production abilities, there is more volume being pumped through these pipelines. This leads to more income for the partnerships, and larger distributions for shareholders.

Uses for natural gas are also broadening, which is very encouraging for the MLP sector. It has taken the United States a long time to embrace the idea of building out a natural gas infrastructure (for vehicles, power generation and other uses).

But with a glut of natural gas now being produced from shale formations, the infrastructure is finally being put in place. This should lead to a dramatic increase in natural gas volume being pumped through the network of pipelines.

Another helpful factor for MLPs is that the broad U.S. economy still appears to be growing, if not as strongly as many would like to see it.

With productivity picking up, energy consumption should increase as well. Once again, this naturally benefits the pipeline companies because they will deliver higher volumes during healthy economic periods.

Do Your Homework Now

Now is a good time to begin building a watch list of MLP positions to invest in once the capital rotation is complete.

Enterprise Products Partners LP (NYSE: EPD) is one MLP worth considering. The company pays a dividend of 4.6% and has a strong network of natural gas pipelines. Another attractive name is Energy Transfer Partners LP (NYSE: ETP). This MLP pays a 7.5% dividend yield and has 6,700 miles of natural gas gathering pipelines.

Building a watch list now will allow you to be prepared when the time is right for purchasing these strong companies. Remember, there are significant risks today. But in time, this sector should turn out to be a tremendous opportunity for yield-hungry investors.

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