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A Basket Approach to MLPs

Editor’s Note: In the December issue of Utility Forecaster, we profiled two midstream-oriented exchange-traded products. As a follow-up to that piece, we had intended to write about our favorite pipeline specialist in the closed-end fund arena, but lacked sufficient space to do so in the forthcoming January issue. So we’re running that article as this week’s e-letter instead.

Given the turmoil among master limited partnerships and the fact that this fund employs significant leverage, it’s really only for aggressive investors in this environment. And before initiating a pilot position, even aggressive investors should monitor the fund over the next several months to get a sense of how the sector’s shakeout will affect its performance. Finally, the fund’s use of leverage means that even if it suits your risk tolerance, it should occupy a smaller position in your portfolio–certainly no more than 5% of overall assets.

While we specialize in choosing individual stocks, we won’t hesitate to recommend a diversified investment if the situation calls for it.

Last month, for example, we profiled two diversified exchange-traded products that track passive indexes of master limited partnerships (MLPs), midstream energy companies formed specifically to throw off lots of cash and offer large distributions.

AMLP and AMJ are excellent for income seekers who want diversified exposure to MLPs to blunt losses in a major downturn like the one presently dogging the energy sector. But for those who favor actively managed portfolios and can handle some extra risk, there’s a more daring option with even juicier payouts—a 30-stock, $1.2-billion fund called Tortoise Energy Infrastructure (NYSE: TYG).

Big Distributions, High Leverage

TYG provides active management through a closed-end fund (CEF) format in which investors’ money is pooled like a traditional mutual fund. However, whereas mutual funds are usually open-ended—they can issue as many shares as needed to accommodate inflows—CEFs have set share counts. They also trade on an exchange and, therefore, can be bought and sold like individual stocks.

CEFs don’t actually have yields per se because payouts may include other types of income in addition to dividends. Any payout is therefore referred to as a distribution rate, which is expressed as a percentage of the fund’s share price.

Income seekers will surely notice TYG’s hefty 10.2% distribution rate. The fund’s four longtime co-managers keep the rate high by investing in U.S. mid- and large-cap MLPs that control some of the energy sector’s most reliable income-producing assets—infrastructure such as pipelines and storage facilities. This enables TYG to make generous distributions regardless of market conditions.

When selecting MLPs, the fund favors those with strong fundamentals such as a history of rising distributions, a proven leadership team and reasonable use of debt. Selections are also based on proprietary stock analysis and valuation models.

TYG’s daring side: It relies a lot on leverage—making investments with borrowed money.

Leverage can boost returns when MLPs are rising because it lets management buy winners without putting up all the required capital. But the strategy works both ways, significantly magnifying losses when portfolio holdings drop in value.

TYG is often highly leveraged. As of December 24, its leverage as a percent of total assets was a whopping 30.2%, though leverage ratios have come down substantially in recent months.

Borrowings include $545 million of bonds maturing over the next decade and a $157.5-million credit line with floating interest charges. There’s also $295 million of TYG preferred stock maturing between 2018 and 2027. Preferred stock is a hybrid security combining ownership features with bond-like fixed-income payments.

Not surprisingly, leverage hasn’t helped TYG’s performance during the current energy sector pullback. Even with its hearty distribution rate, the fund is down 37% on a price basis over the past 12 months, compared with one-year losses of 29% and 36%, respectively, for AMLP and AMJ, which don’t employ leverage.

Among TYG’s worst performers during that time were leading natural gas liquids provider Targa Resources Partners (NYSE: NGLS) and energy transport and storage specialist MPLX (NYSE: MPLX). Both MLPs lost roughly half their value over the past 12 months.

However, some fund holdings have fared surprisingly well in this challenging environment. Prime examples are petroleum products transporter Valero Energy Partners (NYSE: VLP) and Holly Energy Partners (NYSE: HEP), which owns pipelines, storage facilities and distribution terminals across the U.S. These MLPs returned 16% and 5%, respectively, over the past year.

Most important, TYG has a top-notch long-term track record. Over the past decade, it outpaced all of its peers on a net asset value (NAV) basis in the energy limited partnership category, returning 7.8% annually.

Its quarterly distribution per share of $0.655, or $2.62 annually, is about 45% greater than in 2005. Payouts rose nearly 9% this year, despite ongoing energy sector tumult.

Tax Issues, Expenses

Like other exchange-traded products, TYG simplifies tax reporting by sending shareholders a single 1099 form disclosing their portion of fund distributions. There are no K-1s, the often complex tax forms investors have to file when they own shares of individual MLPs.

The fund’s management typically expects distributions to be 80% to 100% qualified dividends eligible for lower capital gains rates. Portions that aren’t may be classified as ordinary income, short- or long-term capital gains, or a nontaxable return of the shareholder’s original investment.

At 1.78% of assets, the fund’s expense ratio is on the high side, but not unreasonable. Expenses are greater because they include leveraging costs and TYG’s added corporate tax burden. As a corporation, the fund pays taxes on earnings before making distributions, whereas individual MLPs do not.

A Timely Value

Though painful, the energy sector crash has made many MLP-focused investments much cheaper, including TYG. Before the crash, the fund typically sold for more than a 12% premium to the value of its underlying assets. But it’s currently trading about 6.1% below NAV, and the discount could further widen if energy prices stay lower for longer, as some analysts predict.

TYG’s price fluctuated 11% more than the MLP category average over the past three years, and the fund will probably always be more volatile because it’s often highly leveraged. But long-term outperformance and a lofty distribution rate make it well worth monitoring as a possible pick-up for aggressive investors as the energy sector approaches its ultimate bottom.


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