This post originally appeared on Forbes.com.
MLPs– Master Limited Partnerships– are back in style. Born in the 80s to incent investment in domestic energy infrastructure, Congress showered them with impressive tax benefits. Like their contemporaries, acid washed jeans and Swatches, they were forgotten for a while, but are du jour again.
Not surprising: the strong income MLPs pay out is more valuable than ever; energy infrastructure construction is roaring as US energy independence looks within reach (this time, for real); and their very special tax benefits are extra juicy. But be careful: it’s surprisingly easy to buy them in the wrong way; and then, shame on you for ignoring a valuable tax gift.
What are MLPs? Well, they’re a bit like other “pass through” investment vehicles you know well: they don’t pay tax at the entity level, and are required to pay out most of their current income to investors. MLPs invest in energy assets, just as REITs focus on real estate and mutual funds on stocks. But MLPs have two special things going for them.
First, aside from being tax exempt and publicly traded, MLPs — and only MLPs — can carry on an active business. That distinguishes them from all other investment vehicles; not just REITs and mutual funds, but the entire alphabet soup (REOCs, ETFs, CEFs, BDCs and a dozen others). And that, in turn, means MLPs can constantly increase their payouts — and they’ve done so, consistently, for many years.
Even cooler is that the income you earn from an MLP investment is strongly tax advantaged. It’s treated as a “return of capital” until you’ve gotten back the full amount of your original investment (if, that is, you buy the right way– see below). So not only are you earning several percent a year, you’re not paying tax on it. Given the solid yields MLPs tend to sport (maybe 5%), that’s a bit like owning a municipal bond paying double the typical rate.
And there’s another huge, but less obvious, benefit of MLPs over munis. Bonds values will plummet if inflation stirs because of so-called interest rate and duration risk (for video explanations of these, see www.altanswer.com). Any yield-oriented investment has some exposure to rising rates, but MLPs are largely protected because of the way they normally increase payouts over time; and that’s why they’ve historically outperformed fixed income instruments in periods of rising rates.
So: a traded security, issued by a tax exempt issuer that can run an active business, which pays a nice, growing, tax-advantaged income stream. All the other investment vehicles are jealous: Congress clearly has a favorite child.
There are many kinds of MLPs, but the ones to start with are the “midstream” variety. These build or buy facilities from “drill bits to burner tips” and then charge energy companies to use them. As a result, payments by most midstream MLPs are effectively backed by many different energy companies, not just one; and often, those companies are large and stable. So these types of MLPs typically carry minimal credit risk.
“Upstream” MLPs are more involved in exploration and development; and the “downstream” variety focuses on processing plants. Both require a bit more expertise than investing in midstream MLPs.
Now, how (not) to buy them? Well, remember that “return of capital” feature is a key element in MLP economics. But it does not pass through to you from a mutual fund, ETF, or ETN investment (and worse: owning a big percentage of MLPs causes those entities to lose their own tax exempt status, so there are two extra haircuts to your yield). So no matter how attractive the yield on a so-called “MLP” mutual fund, ETF, or ETN sounds, you can do better.
Three suggestions: First, just buy them directly into your regular brokerage account. The only downside to that is the research you’ll have to do, plus the fact that you’ll get a “K-1” tax reporting form– annoying, but its probably worth paying an accountant (if you don’t already have one) to handle the extra burden that imposes.
Second, invest with a registered investment advisor that specializes in this space– fact is, there’s a lot to know; and, especially with a high-yielding investment, its probably worth the small management fee to get at the best choices. Especially for upstream and downstream MLPs, I’d recommend this approach.
Third, look at one of the new “registered private” offerings that do not provide daily liquidity, but do pool investments in MLPs, remain tax free themselves, and pass through the “return of capital” benefit. But note that these are for accredited investors only ($1 million of net worth, not counting your residence).
Like any kind of security, MLPs can get overpriced, and some analysts are worried about that right now: they’ve been on a tear for a while. But, in the search for yield, Congress’ golden child is a top candidate.