Master limited partnerships (MLP) have been around for almost three decades–Apache Oil Company, the first such partnership, launched in 1981–but these forbearers differed greatly from the modern-day incarnation. Though intended to facilitate investment in the energy industry, early MLPs gravitated toward exploration and production but also engaged in a wide range of other businesses.

By the end of 1986, there were 34 MLPs that operated outside the oil and gas industry, including offerings involved in restaurants, nursing homes, cable television and mortgage banking.

But many investors learned the hard way that cyclical businesses didn’t necessarily lend themselves to the MLP structure; the worst offerings failed to generate sufficient cash to support their high, tax-advantaged yields.

The modern MLP traces its roots back to the Tax Reform Act of 1986 and the Revenue Act of 1987, which required master limited partnerships to generate at least 90 percent of their income from “qualified” sources–many of which were related to natural resources.

In recent years, energy-focused MLPs have become more popular for the very same reasons as in the mid-1980s: high yields and tax advantages.

 A Compelling Case

Yield chasers have long flocked to MLPs. An article in the March 19, 1987, edition of the Wall Street Journal noted that “in order to be competitive” an MLP needed to yield 9 percent to 10 percent.

Today, MLPs are an attractive alternative to a frothy bond market, where spreads on high-yield issues appear insufficient to compensate for underlying risks. And whereas the S&P 500 yields 2 percent and the MSCI US REIT Index yields 3.4 percent, the Alerian MLP Index yields about 5.8 percent.   

The group’s safety has also been a selling point to investors seeking reliable income streams: Many MLPs managed to maintain their quarterly distributions throughout the 2008-09 credit crunch and collapse in oil and gas prices. Over the past two years, investment banks and asset management firms have launched more than 23 funds focused on MLPs.

The accompanying marketing efforts often tout the safety of midstream energy partnerships, likening these businesses to “toll roads” that generate reliable fee-based income regardless of commodity prices and economic conditions–an appealing pitch to investors scarred by

MLPs also offer significant tax advantages. As pass-through entities, MLPs don’t pay federal income taxes at the corporate level. They spread this responsibility among unitholders.

This tax relief is a huge advantage when these firms compete with traditional corporations for acquisitions–one way in which MLPs grow their distributions. And investors avoid the double taxation to which corporate dividends are subject. (The government taxes corporation’s earnings as well as the dividend payments received by individual investors).

Better yet, the Internal Revenue Service generally treats 80 percent to 90 percent of the distribution investors receive as a return of capital, limiting current tax liability. Rather, the amount paid is subtracted from the cost basis; taxes are due as a long-term capital gain when you sell your position.

In other words, 80 percent to 90 percent of the distribution you receive from an MLP is tax-deferred. The remaining piece of each distribution is taxed at normal income tax rates, not the special dividend tax rate. But the piece taxed at full income tax rates is only 10 percent to 20 percent of the total distribution–a substantial deferred-tax shield.

The group could become even more attractive in 2013, when the top rate on dividends is slated to increase from 15 percent to 20 percent in the best case or nearly 40 percent in the worst case.

Pitfalls and Opportunities

All too often, investors focus on a partnership’s yield rather than its underlying business. This shortsightedness is hardly a new problem. Writing for the Wall Street Journal in March 1987, Barbara Donnelly noted, “Investors are focusing too much on yield, ignoring whether the underlying business can really support such high payouts.”

Twenty-five years later, investors are prone to the same mistake. Although the financial crisis and stock market implosion of 2008 and early 2009 chastened investors about the dangers of reaching for high-yielding names, many continue to pursue the same shortsighted strategy in an effort to recover the wealth they lost three years ago.

At the same time, the Alerian MLP Index’s yield has declined from about 7.5 percent in the first quarter of 2010 to 5.8 percent today. In recent months, robust inflows into the group’s blue chips–Kinder Morgan Energy Partners LP (NYSE: KMP), Enterprise Products Partners LP (NYSE: EPD) and Plains All American Pipeline LP (NYSE: EPD)–have pushed these stocks to 52-week highs and lowered current yields.

Rather than speculating on high-yield fare or overpaying for steadier names, investors should consider setting buy-limit orders at attractive prices on less-risky names. We expect the stock market to remain volatile over the coming year and wouldn’t be surprised if equities swooned for the third consecutive summer. With the US economy growing at an anemic rate and the ongoing EU sovereign-debt crisis unlikely to be resolved soon, investors should have ample opportunity to pick up units of some overbought at MLPs at favorable prices.

Initial public offerings (IPO) also provide investors with an opportunity to lock in high yields on quality MLPs. Many financial websites misreport the yields on these fledgling stocks until the MLP has paid several quarters’ worth of distributions. Savvy investors often have an opportunity to buy these names at a discount before the yield-hungry herds rush in.

MLP IPOs surged in 2011 after taking a breather from 2008-10, reflecting strong equity markets and rising demand among investors for high-yielding securities and the tax advantages associated with the structure. (See The Case for MLPs: Investor Psychology and Demographics.) 

Source: Bloomberg

We expect this trend to continue as energy infrastructure owners seek to monetize energy-related assets.

Investing in MLP IPOs can be lucrative, but selectivity is critical to distinguishing the winners from the losers. Some new MLPs boast solid assets and a workable strategy to grow their distributions; others go public so their sponsors can exit their position and turn a profit.

Understanding the difference between solid and questionable MLP IPOs requires taking a close look at the firm’s underlying assets and growth prospects.

Consider the timing of Niska Gas Storage Partners LP (NYSE: NKA) and PAA Natural Gas Storage (NYSE: PNG), which went public in quick succession in late spring of 2010.

At the time, fundamentals in the gas storage business had started to deteriorate. Demand for storage capacity hinges on the spread between summer-winter spread in natural gas prices. Traders often purchase inexpensive gas during the spring and summer (periods of relatively weak demand), and sell these inventories for higher prices in the winter (a period of higher demand and inventory withdrawals).

However, the glut of production from the nation’s prolific shale gas plays has eroded the winter-summer spread and potential profits, reducing demand for storage. Curiously, both MLPs sponsors–private-equity firm Carlyle/Riverstone and Plains All American Pipeline LP (NYSE: PAA)–saw fit to spin their gas storage assets off in the year that the US overtook Russia as the world’s leading producer of natural gas.

Both MLPs have pulled back substantially this year, as the winter-summer spread has eroded considerably. This headwind is likely to persist for at least the next two to three years, pressuring pricing on contracts up for renewal. During Plains All American Pipeline and PAA Natural Gas Storage’s joint conference call to discuss fourth-quarter results, one analyst asked if the sponsor would consider rolling up PAA Natural Gas Storage if business conditions deteriorate further.

Niska Gas Storage Partners, however, is arguably in worse shape: Only 60 percent of the MLP’s storage capacity is covered by long-term contracts, and management suspended distribution payments on the subordinate units because of a shortage in cash flow.

Remember the lessons of the 1980s: Forget the yield–instead focus on the underlying fundamentals of each MLP in your portfolio.

Around the Portfolios

Fourth-quarter earnings season is under way. Here are the confirmed and estimated reporting dates for our MLP Profits Portfolio holdings. All dates marked with an asterisk are estimated.

Aggressive Portfolio:

Legacy Reserves LP (NSDQ: LGCY)–March 3, 2012*
Linn Energy LLC (NSDQ: LINE)–Feb. 24, 2012*
Navios Maritime Partners LP (NYSE: NMM)–Jan. 24, 2012
Penn Virginia Resource Partners LP (NYSE: PVR)–Feb. 9, 2012
Regency Energy Partners LP (NYSE: RGP)–Feb. 16, 2012
Vanguard Natural Resources LLC (NYSE: VNR)–March 1, 2012

Conservative Portfolio

Genesis Energy LP (NYSE: GEL)–March 2, 2012*
Kinder Morgan Energy Partners LP (NYSE: KMP)–Jan. 18, 2012
Magellan Midstream Partners LP (NYSE: MMP)–Feb. 7, 2012
Spectra Energy Partners LP (NYSE: SEP)–Feb. 3, 2012

Growth Portfolio

DCP Midstream Partners LP (NYSE: DPM)–Feb. 24, 2012*
Energy Transfer Partners LP (NYSE: ETP)–Feb. 16, 2012*
Targa Natural Resources LP (NYSE: NGLS)–Feb. 23, 2012
Teekay LNG Partners LP (NYSE: TGP)–Feb. 24, 2012*