Much Ado About Rates

Was it only a month ago that MLPs were hyped as the hot new Hollywood craze? Has it really been just two weeks since an uncommonly bullish industry conference all-but-yawned at rising bond yields?

It’s almost hard to recall how it felt at the time. Because now I get perfectly sensible reader mail like this:

“What has driven the 5-8 percent drop in the MLP Model portfolio over the last two weeks? If the key driver has been concern about a tapering in QE and a gradual increase in interest rates that would dampen the attractiveness of the MLP payouts/unit and increase their overall cost of capital, is this the end of the bull run of MLP and are we likely to see a further 20 percent-plus  contraction. If not why not and if yes should we be pulling money off the table?”

Losing money is never fun, and perhaps even less so with MLPs, which are held for income and whose much bandied tax advantages accrue mostly to long-term investors and (especially) their heirs.  But you didn’t subscribe for the therapy so let’s get into why rates have been going up and how much trouble MLPs are in.

The first thing to note is that the 10-year Treasury yield is just 10 basis points (each basis point is 1/100th of a percentage point) from where it stood in early March, lower than in April 2012 and a full percentage point below the yield in late June 2011 in the heat of the budget ceiling fight, when things were officially Very, Very Bad.

10-Year Itch: The End of the World as We Know It?

10-year Treasury yield chart

That impasse produced a US credit downgrade that proved irrelevant and fiscal austerity (as mandated by the whole ill-starred sequester compromise) that has a whole lot of relevance to why bond rates are so much lower two years later, despite the employment and housing gains we’ve seen since.

The low rates are often disparaged as a twisting of market forces by the Federal Reserve, and I can’t think of another mindset that has cost investors as much money in the last five years. Low rates reflect the reality of abnormally high unemployment, minimal inflation and stagnant incomes for the vast majority of workers. They are a byproduct of the fact that the economy is operating far below its potential, and all the bond buying by the Fed remains an essential holding action until animal spirits revive or, at the very least, the need to replace that 12-year-old clunker can be denied no longer.

 So rates are not going to run away to the upside while the Fed remains a bulk buyer of long-dated government bonds, a policy it’s unlikely to reverse until the economy gets much stronger. The Fed has made this crystal clear, and in case anyone doubted its resolve it spelled out the targets that must be hit before it even considers hiking rates.

Those bogeys are a 6.5 percent unemployment rate and inflation projected to rise above 2.5 percent. Right now unemployment is at 7.6 percent and the Fed’s preferred inflation measure, the personal consumption `expenditures price index, is up 0.7 percent year-over-year, weighed down by outright price declines for durable and nondurable goods, as well as energy.

Federal Reserve Chairman Ben Bernanke and dovish allies like San Francisco Fed President John Williams have said they might reconsider the volume of bond purchases over the next several meetings, and they will. And when they do they will consider their stated objectives, the rate of economic progress and go right on buying. Signs of such progress have become noticeably scarce of late, with cyclical recoveries in housing and autos offset by weakness overseas and, more importantly, austerity in Washington. The Fed is not going to “taper,” much less reverse its quantitative easing if things keep trending the way they have been trending recently.

When it does taper, it will be because the economy is really stronger, and it will be a bullish development for equities, including partnerships tasked with upgrading America’s energy infrastructure. Because MLPs are not abstract yield plays but companies with a surplus of potential projects promising double-digit returns right now, on capital that costs them maybe 5 percent.

That infrastructure needs a lot of upgrading, as the industry makes a big transition from crude imports to exports of processed fuels. Moreover, it needs to transport vast amounts of energy from booming resource basins in places like North Dakota and Pennsylvania, where demand for such services continues to outpace supply. The notion that this enterprise will be endangered by a stronger economic recovery and the higher rates it would foster over time doesn’t wash even if you believe, as I do, that we’ll get one in the next year or two.

Enterprise Products Partners LP (NYSE: EPD) has returned 450 percent over the last decade. Kinder Morgan Partners LP (NYSE: KMP) has grown distributions from $17 million in 1996 to an expected $4 billion this year, a compounded annual rate of 38 percent. Without the yield, they would be known as incredibly successful growth companies, and not dependents on the Fed keeping things as is.

A sharp runup in rates would certainly make them temporarily less attractive. But a sharp runup in rates is exactly what’s not in the cards given current economic conditions and their conceivable evolution over the next six months. So treat this scare as the opportunity it is to pick up proven winners at a modest discount.

In This Issue

The portfolio update that follows reviews all the MLPs in our portfolios, and the unavoidable conclusion for several is that they deserve higher buy-under targets.  See Portfolio Update.

Two of our longtime favorites have invested heavily recently in new assets that should boost returns for years to come. Get the details in Best Buys.

Investors in MLPs must be aware that the general partner making all the decisions won’t necessarily act in their best interest, as the recent events at Inergy Midstream Partners demonstrate.  See In Focus.

General partners endowed with lucrative incentive distribution rights have strongly outperformed the limited partnerships paying such incentives in recent years. We’re adding the two biggest and safest publicly traded GPs to our Growth Portfolio. See Sector Spotlight.   


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