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How to Avoid Getting Burned by High Yielders

By Ari Charney on September 15, 2017

Like all income investors, I want to get paid regularly—preferably as much as possible.

At the same time, I’m not a yield chaser who blindly buys dividend stocks without understanding the source of their payouts.

I want to know how a company funds its dividend and understand how offering a payout fits in with a firm’s overall strategy.

After all, companies aren’t paying investors dividends out of the kindness of their hearts. And when hard times hit, they may not consider the dividend as sacrosanct as you do.

Of course, not everyone is interested in learning how and why they get paid. And some securities are so complex that even reasonably curious investors give up trying to figure things out.

The resulting ignorance is almost childlike.

A Steady Allowance

Recently, my wife started our six-year old on an allowance because she wants him to learn the value of money and how to spend it wisely. She’s been giving him $6 a week—“Because I’m six!” he quipped.

Now, he’s got a stream of income from a regular payout, not unlike a dividend stock.

But as with everything these days, the so-called experts have made things needlessly complicated.

Unlike when I was growing up, an allowance isn’t supposed to be tied to completing chores, doing well in school, or, at the very least, being polite and respectful on a daily basis.

We’re just supposed to pay him for being our kid, I guess.

And instead of handing him six bucks each week and simply leaving it at that, she’s using the three-jar method, which is the latest parenting trend foisted on us by our betters.

The first jar is labeled “Spend,” the second “Save,” and the third “Share.”

Somehow I suspect “Save” and “Share” will end up collecting nothing more than dust.

So far, this process means he has no idea where our money comes from, why he’s getting paid, or how to turn income into wealth. But he does know he wants to get rich.

Master of Reality

Many who invest in high-yielding master limited partnerships (MLPs) are similarly disconnected from how they’re getting paid and why.

When times are good, it doesn’t seem to matter.

But when the energy sector falls apart, it can make all the difference in the world, especially for investors who depend on their portfolios to generate current income.

While all MLPs took a hit during the energy sector’s crash, some did something even worse: They slashed their payouts.

Naturally, that caused their prices to fall even harder, leaving risk-averse income investors holding a busted stock that just gave them a massive pay cut.

At Utility Forecaster, we look for MLPs with rising cash flows that drive their prices and quarterly payouts higher over time.

Right now, one of our longtime MLP holdings currently yields nearly 9%, while one of the newer additions to our portfolios is on track to grow its quarterly payout more than 20% annually over the next four years.

Part of our approach is grounded in knowing why an MLP exists in the first place. If you understand that, it could save you from a big headache later.

The Best of Both Worlds

An MLP is typically created by a larger parent company, or sponsor, such as an energy producer, pipeline company, or utility that owns slow-growing but dependable assets that produce steady returns with minimal maintenance.

Government-regulated pipelines that transport oil or natural gas from the wellhead to the market are a perfect example of such an asset.

So what’s in it for the parent company?

Sponsors use their MLP subsidiaries as a cheap way to raise money to invest in new growth, while still getting a taste of the cash flows generated by their former assets.

From the sponsor’s perspective, it’s the best of both worlds. No wonder even conservative utilities such as Dominion Energy (NYSE: D) got in on the game.

Here’s how it works.

The parent company typically includes at least one sizable income-producing asset with the MLP when it launches its initial public offering (IPO).

An MLP’s IPO gives the parent company a big payday along with a sizable equity interest in its newly created subsidiary.  

Thereafter, the parent will sell similar assets to its MLP with each passing year, which gives it a recurring source of capital while also driving growth in its subsidiary’s cash flows and payout.

The parent can then take the proceeds from each sale of slow-growing assets and redeploy them toward faster-growing investments.

In addition to cash, the parent usually receives a bigger equity stake in its MLP subsidiary as part of each sale.

That’s one way it still gets a taste of the cash flows generated by its former assets. The other way is more consequential for the sponsor and MLP investors alike.

Sweet Haul

Sponsors also own an MLP’s general partner, which manages the MLP’s operations. As part of this arrangement, the general partner owns incentive distribution rights (IDRs) in the MLP.

IDRs are essentially another income stream for the parent. But they’re structured in such a way to give the general partner a bigger and bigger distribution over time as certain performance thresholds are met.

In other words, IDRs give the parent a supercharged payout.

Eventually, this can become a real drag for investors who only own a stake in the limited partner.

Initially, however, it’s a crucial growth driver for a young MLP because it incentivizes the parent to regularly drop down new income-producing assets to its subsidiary.

But at some point, IDRs siphon off so much cash that that they can jeopardize the sustainability of an MLP’s payout. We saw that happen to a number of major MLPs during the energy sector’s crash.

The shrewdest players foresaw such a day and acquired their general partners well before the downturn. That enabled them and their investors to endure the sector’s decline with relative equanimity.

This is why it’s so critical for income investors to understand how and why they’re getting paid.

In exchange for spending a little time learning the ins and outs of these securities, you’ll know how to pick the right ones and enjoy a high tax-advantaged payout through thick and thin.

And that’s the best of both worlds for income investors.

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