MLPs, or master limited partnerships, are publically traded partnerships that operate in the natural resources, commodities or real-estate spaces, and are not taxed at the entity level. They provide steady, relatively high yields and investors are only taxed when they sell their units.
Q. Hard to believe we haven’t talked much about these, because they can be an extremely attractive “alt” investment, right?
A. They certainly can be, for one very good reason: excellent income. MLPs were created by Congress back in the 80s to foster energy independence, and there are about 85 of them now, with a total market cap of about $300 billion. MLPs are master limited partnership, so they are not taxed at the entity level, and their “units” trade on public exchanges.
Q. So, aside from not being taxed at the entity level, what are the big attractions?
A. There are 3 big ones. First, again, high yields… they’re averaging about 6% right now, which looks pretty good in a zero interest rate environment. Second, that income that comes back is considered a return of capital, meaning that you don’t pay tax on it until you sell the MLP unit. Third, MLPs can and do grow their businesses– they are operators. So the yields can grow with the businesses.
Q. That’s unique, isn’t it? Because REITs and Royalty Trusts, for example, generally don’t actually manage and operate businesses, they just collect passive income.
A. Yes, that’s a key point. The normal price you pay for having a public entity that doesn’t pay corporate tax is that it must remain passive. MLPs have a big leg up on other kinds of business organizations for that reason.
Q. OK, it all sounds pretty good. What are the downsides?
A. Well, because it’s still a yield play, there is some duration risk… but the fact that they operate businesses and their income can grow — right now they’re growing around 6% per year — helps offset that.
Q. What about investing through a mutual fund or ETF to get diversity?
A. You can do that, both exist. But that way of investing has a big downside, too… due to some arcane tax rules, MLPs held by mutual funds or ETFs effectively do attract an entity level tax, so you’re losing that benefit. You can also invest in them through closed end funds, but they carry big sales fees. Direct ownership is best.
Q. What else do we need to know?
A. Two more details. If you invest directly in MLPs, you’ll wind up filing tax returns in all the states in which it operates, which can be annoying. And note they’re not really appropriate for an IRA because they’re mostly already tax free, and they can also throw off “unrelated business income”, a no-no for IRAs.
Q. Bottom Line?
A. I think it’s pretty clear that these are extremely attractive vehicles right now. They are providing uncorrelated high yield, are liquid, and don’t have the same vulnerability to duration risk that true fixed income investment do because, again, of the growth potential. Of course, like anything, you still have to buy in at reasonable prices, but MLPs are worth a look for most investors.