After over a year of steady gains with little more than the periodic 5 percent setback, volatility has returned to the broader market. The S&P 500 remains range-bound, trapped between a floor near 1,010 and a ceiling near 1,130. Daily moves occur in the order of 2 to 3 percent.

Despite volatility in the broader market, investors in master limited partnerships (MLP) have enjoyed yet another nice run-up. The industry benchmark Alerian MLP Index slipped in May but hit fresh 52-week highs in July. Meanwhile, the Alerian MLP Total Return Index–which includes reinvested dividends–has touched new all-time highs.

When MLPs were selling off alongside the broader market indexes in May, many subscribers asked if the weakness stemmed from a fundamental problem. Our response, as least for our Portfolio recommendations, was that the selling was simply due to spillover from weakness in the broader market.

Several of our favorites issued bonds or took on new credit lines at the height of the EU credit panic–remarkably, the rates were in-line or slightly lower than last autumn. The best MLPs never suffered a credit crunch.

In short, the fundamentals remained strong, and fears of a credit freeze were overdone; the selloff represented an outstanding buying opportunity.

Two months later, many readers are asking if it’s too late to invest in our recommended MLPs now that the Alerian MLP Index has touched new highs. Broadly speaking, MLPs don’t appear to be overvalued; the graph below provides a closer look.

Source: Bloomberg

We’ve posted this graph on several occasions since we began the service a little over a year ago. Investors buy MLPs for their high and rising distributions; it’s logical to compare the yield on the Alerian MLP Index with the yields on other income-oriented investments. In this case, we compare the Alerian’s yield to the yields on BBB-rated corporate bonds and real estate investment trusts (REIT).

At present, the Alerian MLP Index yields roughly 6.7 percent, down nearly 100 basis points (1 percent) from its May lows. This doesn’t mean that MLPs have cut their payouts; rather, the rally in the Alerian MLP Index caused the yield to decline. With the yield on a 10-year US Treasury at about 2.9 percent, the Alerian MLP Index offers slightly less than 400 basis points (4 percent) more yield than the 10-year Treasury.  

The average yield spread for the Alerian MLP Index over the four-year period covered in the graph is 363 basis points; the index offers a significantly higher-than-average yield spread to Treasuries. This is a technical way of saying that you’re being paid more to hold MLPs than would normally be the case.

Also, note that this average is skewed to the upside by the financial crisis of 2008 and early 2009. During the credit freeze, investors flocked to US government bonds as a safe haven, pushing the yield on the 10-year Treasury down to around 2 percent at its lows in late 2008.

At the same time, investors indiscriminately sold stocks to raise cash, propelling the yield on the Alerian MLP Index to as high as 12 percent. Even rock-solid MLPs that have consistently raised their distributions yielded in excess of 10 percent at their lows.

If we exclude the period from mid-August 2008 to mid-April 2009, the average yield spread for the Alerian MLP Index drops to less than 300 basis points. On that basis, the current yield on the Alerian looks even more attractive.

And yields offered by traditional income-producing groups are far less enticing. The Bloomberg REIT Index currently yields about 114 basis points over 10-year Treasuries, less than one-third the spread offered by the Alerian MLP Index. The 2006-2010 average yield spread for REITs is just shy of 140 basis points; the Bloomberg REIT Index offers a lower-than-average spread to Treasuries. Meanwhile, the yield on BBB-rated industrial bonds is about 235 basis points, while the four-year average is 2.62.

Simply put, the Alerian MLP Index offers an attractive yield relative to historical norms and compared to other income-producing groups.

Risk, Reward and Buying Tactics

Investing is all about balancing risk and reward. Comparing the Alerian MLP Index’s yield spreads to those of other income-producing groups is a useful exercise that can help identify when an asset class is undervalued or overvalued. But yields mean nothing unless the underlying businesses that support these payouts are able to generate the cash flow needed to sustain distributions. Before making an investment, you need to examine the business risks of each MLP.

As we’ve written on many occasions, one of the worst possible strategies when investing in MLPs is to blindly chase yields. The MLP investment landscape is littered with examples of partnerships that became popular because of high double-digit yields–yields that were ultimately unsustainable because of business conditions.

A classic example is K-Sea Transportation Partners (NYSE: KSP), a tank barge MLP that we’ve rated “Sell” in our How They Rate Portfolio since the inception of MLP Profits. A year ago K-Sea was among the most asked-about MLPs in our coverage universe thanks to its high yield and solid long-term performance.

But we advised readers to steer clear of K-Sea because the long-term contracts on several of its barges were slated to expire. We felt the firm wouldn’t be able to renew those deals at similarly attractive rates.

These fears came to fruition last autumn, forcing K-Sea to slash its distribution. In response, the stock plummeted from the low $20s in early October to around $5 today. In February K-Sea discontinued its distributions entirely to save cash while it waits for the tanker barge market to recover.

Our Conservative Portfolio recommendations have little exposure to commodity prices and prevailing economic conditions. For the most part, these companies own and operate pipelines, receiving a fee for transporting oil, natural gas and refined products. The average indicated yield for Conservative Portfolio picks is less than 6.2 percent; as these MLPs have the lowest business risks, they offer a lower yield.

In contrast, our Aggressive Portfolio holdings tend to have a bit more exposure to commodity prices. Most, like Linn Energy LLC (NasdaqGS: LINE), Encore Energy Partners LP (NYSE: ENP), EV Energy Partners LP (NasdaqGS: EVEP) and Legacy Reserves LP (NasdaqGS: LGCY), are involved in the actual production of oil and natural gas. Production-related revenues depend on the price of the energy commodities in question. To mitigate this uncertainty, most of our favorites use futures, options and swap contracts to reduce their exposure to the value of oil and gas.

But hedges eventually expire, and these firms’ exposure to commodity prices means that we demand a higher yield to compensate for the risks involved. Our average Aggressive recommendation offers a yield of close to 9 percent, well above the average yield on the Alerian MLP Index.

Remember, an MLP that yields 9 to 10 percent and has the business strength to raise its distributions over time is a better investment proposition than a partnership that yields 12 to 13 percent and is likely to cut its payout because of weak fundamentals.

In the July 12, 2010, issue MLP Profits, Roger offers a detailed rundown of exactly what we look for when evaluating the safety of an MLP’s distributions.

We take all these factors into consideration when setting the buy targets outlined in the Portfolio tables. We do not recommend buying any MLPs that trade above these targets. Just three weeks ago, almost all of our recommendations traded above their targets; as of July 19, eight of our 19 recommended MLP still traded below our buy targets.

Just because an MLP trades above its buy target doesn’t mean you should sell; instead, you should hold off on adding to your position until the MLP drops below this target. Also note that we frequently adjust buy targets–particularly during earnings season–to reflect distribution increases andother fundamental developments. If you follow our strict buy methodology carefully and are patient, we’re convinced you’ll boost your returns. Here are three additional tactics for timing your entry into our recommended MLPs.

Try using some limit orders. In the July 12 issue, Roger also explained why we don’t recommend the use of stop and trailing stop orders for MLPs. However, one useful technique for investors involves the use of limit orders, an order you leave with your broker to automatically buy (or sell) a stock at a predetermined limit price.

Assume you wish to buy an MLP that trades at $55 for under $53 per unit. You could set a limit order at $52 or $53 per unit to buy the MLP. As soon as the MLP is available at or below that limit price, your broker will automatically buy it for you. You don’t have to be at your desk or even watching the market when the trade is executed.

I’ve spoken to a handful of subscribers who had limit orders set up on several of our recommended MLPs during the so-called “Flash Crash.” Some MLPs traded 30 percent lower during the day before closing flat or down a percent or two at the close. Investors with limit orders in place were able to pick up units at deeply discounted prices; those with stop orders were sold out at the worst possible time.

Watch for Flash Alerts from MLP Profits. Often, individual MLPs will suffer a short-term selloff after announcing a secondary offering of units. As we’ve explained before, when an MLP issues new units it dilutes the value of existing holders, prompting a wave of selling.

However, MLPs typically issue units to raise capital for new acquisitions or projects, such as the construction of new pipelines. These short-term selloffs often offer outstanding opportunities to buy into well-placed MLPs at a sizeable discount.

Since this publication’s debut, every single MLP we recommend that’s issued new units in a secondary offering is now trading higher than it was before announcing that offering. That’s a spectacular track record. We normally issue a Flash Alert to all subscribers when such opportunities emerge; it’s important to keep some powder dry to take advantage of those periodic sales.

We also issued several Flash Alerts concerning the Flash Crash and market pullback in May, indicating that the time was right to by the group.

Don’t spend it all in one place. I’m often contacted by new subscribers who tell me they have some lump sum–say $60,000–to invest in our Portfolio recommendations. They want to know if they should invest all of that money now or wait for a pullback.

It’s only natural that investors fear putting a significant amount of money to work in a group that’s just had a nice run-up; no one wants to buy at the highs and miss out on a pullback. However, there’s an equally large risk in waiting for a correction; the MLPs you’re looking to buy could run up another 20 or 25 percent.

One solution is to divide the sum you wish to invest into pieces and buy into the group over time. If you want to invest $60,000, you could buy $20,000 worth of MLPs immediately and look to commit the remainder over the next six months or so. This way, if the market keeps running, you’ll have some exposure to the upside. And if a significant correction occurs, you’ll have plenty of dry powder to take advantage of the myriad buying opportunities. Given the low commissions available these days, there’s no longer much of a disadvantage in buying MLPs over time.

MLP News

The next big market-moving event for the MLPs is second-quarter earnings season, which gets underway later this week. We expect the group to report solid results–in fact, several MLPs have already jumped the gun and announced increases to their quarterly distributions ahead of earnings releases.

Of the 50 MLPs in the Alerian MLP Index, eight have already announced their second-quarter distributions, and seven of the eight will pay more this quarter than a year ago. The average increase is a little over 5.5 percent, and no MLP has announced a cut to their payout for the quarter.

Conservative Portfolio recommendation Enterprise Products Partners LP (NYSE: EPD) announced that it will pay a distribution of $0.575 on August 5, 2010, to unitholders of record as of July 28. This represents a 5.6 percent increase over the same quarter one year ago and a 1.3 percent boost to the MLP’s payout in the previous quarter.

Enterprise is a model of consistency; this marked the firm’s 24th consecutive quarterly distribution increase. And the MLP has plenty of new projects on tap that should keep its record of consistent increases unblemished. The latest effort is a near $2 billion expansion of its pipeline and gas-processing business in southern Texas.

These assets are designed to serve the Eagle Ford Shale, a field that contains significant volumes of oil, natural gas and natural gas liquids (NGL). Thanks to the Eagle Ford’s low cost of production and its reserves of high-value oil and liquids, drilling activity is picking up–the region requires additional capacity to transport and process oil and gas. Enterprise is among the best-placed MLPs to serve the field; it already boasts nearby assets that it can scale to handle more volumes without having to build a vast new network from scratch.

In light of its higher payout and continued strong growth prospects, we’re boosting our buy target on Enterprise Products Partners LP from 36 to 38.

Fellow Conservative Portfolio holding Genesis Energy LP (AMEX: GEL) also announced a distribution increase for the quarter. The MLP will pay $0.375 per unit on August 13 to shareholders of record on July 30.That represents an 8.7 percent increase over the year-ago quarter and a more than 2 percent over the first quarter of this year.

The pipeline operator announced that it had secured a new $650 million credit facility that expires in 2015, replacing a $500 million credit line that was due to mature next year.

This is yet more proof that MLPs have outstanding access to capital despite sovereign credit concerns in Europe. Not only was Genesis able to extend the term of its borrowing facility but it also was able to increase the total amount of credit it has available to fund growth. Genesis Energy LP is a buy under 21.

Refined products pipeline operator Magellan Midstream Partners LP (NYSE: MMP) announced that it will acquire oil storage facilities and oil pipelines for $289 million from BP Pipelines, a midstream energy unit of BP (NYSE: BP). This makes Magellan one of the first companies to benefit from BP’s struggles in the Gulf of Mexico.

Integrated oil companies such as BP and Conoco Phillips (NYSE: COP) own significant midstream energy assets that fit perfectly within the MLP structure.

Midstream assets generate dependable cash flows but don’t grow production. Most integrated oil firms are valued based on their ability to show growth in oil or gas production; it makes strategic sense to sell off midstream assets and deploy the capital in exploration and production projects. And because MLPs don’t pay any tax at the corporate level, these cash-generative assets are far more tax efficient when held within an MLP structure.

Meanwhile, the cash flows generated by such assets are just what MLPs need to back up their generous distributions to unitholders. 

For years integrated oils have sold midstream energy assets to MLPs. But BP’s challenges and desire to raise $10 billion in cash via asset sales over the next year likely accelerated these plans; Magellan took advantage by picking up outstanding assets at a good price.

In particular, we like that Magellan acquired nearly 8 million barrels of oil storage capacity at the key US crude oil hub in Cushing, Okla. The deal includes a long-term contract with BP that guarantees Magellan a minimum level of cash flow for leasing the storage. But even in the event BP were to declare bankruptcy or be acquired, storage capacity at one of America’s busiest and most important oil hubs is extremely valuable; Magellan would have little trouble signing new contracts. And the pipelines and storage facilities fit well with its existing assets.

Magellan is selling 5 million units in a secondary unit offering to cover the costs associated with the deal. In a sign of underlying strength, the MLP was able to sell those units at a price of $46.65 per unit, a roughly 5 percent discount to Magellan’s all-time highs. Even better, within four business days the stock rallied back to where it traded before the offering. When a stock rallies this soon after announcing a secondary offering, demand for the security remains strong.

Bottom line: Magellan’s acquisition of new pipeline and storage assets should be immediately accretive to cash flows and allow the MLP to boost its distributions to unitholders. Magellan Midstream Partners LP rates a buy on dips under 47.

Popular New Funds

Another factor that’s helped push MLPs higher in recent weeks is the launch of several new funds that invest in the sector. These funds offer high yields and have attracted a good deal of investor attention; as more investors pile into the funds, the managers are forced to add to their positions in the group, supporting valuations.

A trio of new exchange-traded notes (ETN) issued by Swiss banking giant UBS (NYSE: UBS) appear to be garnering the most attention.  

UBS E-Tracs Alerian MLP Infrastructure (NYSE: MLPI) is designed to track the performance of energy-infrastructure MLPs. Top-weighted constituents include Enterprise Products Partners, Kinder Morgan Energy Partners LP (NYSE: KMP), Enbridge Energy Partners LP (NYSE: EEP), Energy Transfer Partners LP (NYSE: ETP) and Magellan Midstream Partners LP.

These five MLPs account for about 40 percent of the ETN’s investable assets, and four of the five are recommended in the MLP Profits Portfolios. This particular ETN doesn’t include any MLPs involved in upstream energy businesses.

UBS E-Tracs Alerian Natural Gas (NYSE: MLPG) is designed to track the performance of the largest MLPs involved with natural gas-related infrastructure assets. The list includes Copano Energy LLC (NasdaqGS: CPNO), Spectra Energy Partners LP (NYSE: SEP), Targa Resources Partners LP (NYSE: NGLS) and Duncan Energy LP Partners (NYSE: DEP).

Finally, UBS offers UBS E-Tracs 2x Leveraged Long Alerian MLP Infrastructure Index (NYSE: MLPL). This ETN tracks the same index as “MLPI” but employs leverage to double the performance of the index. The yearly fee for all three ETNs is a reasonable 0.85 percent.

The 2x Leveraged Long ETN is likely to garner the most attention from retail investors, as the leveraged exposure to MLPs means that it not only offers double the performance of the index but also roughly twice the yield. Although the income generated by the ETNs will vary over time, UBS’ website currently indicates that the 2x Leveraged ETN will pay a yield of nearly 12.9 percent, compared to 6.6 percent for the Natural Gas ETN and 6.9 percent for the Infrastructure ETN.

An ETN is only as good as the index and MLPs that it tracks. As noted above, the infrastructure fund and the 2x leveraged ETN include a significant weighting in MLPs that we recommend in the model Portfolios. That being said, whenever you buy an exchange-traded fund (ETF) or ETN you’re actually buying the good, the bad and the ugly within the index; the UBS ETNs include several MLPs we rate only “Hold” or “Sell” as major holdings. The ETNs also provide little to no exposure to some of our best-performing recommendations, including Linn Energy and Navios Maritime Partners LP (NYSE: NMM).

And before investors jump on that 12.9 percent yield, several factors are worth considering.

These three products aren’t exchange-traded funds but exchange-traded notes. ETNs are actually a form of debt issued by the sponsoring institution–in this case, UBS. In other words, when you buy the ETN you’re exposed to credit risk in UBS.

Also, because these products are ETNs, the quarterly distributions you receive are reported on a normal 1099 form rather than on the K-1 Partnership form used to report income from individual MLPs. In addition, the income you receive is ordinary income, NOT qualified dividends or partnership distributions.

Ordinary income is taxed at your full income tax rate, which is likely to rise considerably in coming years as the Bush tax cuts expire and new taxes related to health care reform legislation go into effect. You won’t receive any of the income-tax deferral benefits associated with owning individual MLPs. One upside of this is that ETNs are an ideal candidate for IRAs and other tax-advantaged accounts.

The UBS ETNs are all designed to track monthly returns in the underlying index. Many ETFs and ETNs suffer from tracking error–that is, the funds don’t always reflect the performance of the index or commodity they’re designed to track because of the frequency with which the portfolios are rebalanced.

Some of the worst culprits are exchange-traded products designed to track daily performance–these offerings are suitable primarily for shorter-term holders. One would expect a monthly product like the three UBS ETNs to suffer from less acute tracking error issues, though their limited history means that it’s tough to make that assessment until we have more trading data to analyze.

And tracking error doesn’t apply solely to capital gains from the ETN as compared to the underlying index. There’s also no guarantee that the ETN will pay double the yield on the underlying index; that, too, will depend on exactly how and when the index is rebalanced.

Finally, note that leverage works on both the upside and downside. For example, the Alerian MLP Index pulled back roughly 15 percent from its closing high in April to its closing low in May. Our Conservative Portfolio held up a bit better than that, while some of our Aggressive recommendations suffered larger corrections than the index as a whole.

Investors should expect occasional corrections of 5 to 20 percent in the group, but those with longer investment horizons shouldn’t panic; for these investors, such pullbacks offer a buying opportunity.

Assuming the 2x leveraged UBS ETN performed according to plan, it would have likely corrected more than 30 percent from its April highs to its May lows. The question every investor needs to ask is whether they’re willing to accept that level of volatility from their investments. There’s no free lunch: The reward is twice the yield; the cost is twice the risk.

It’s often a good idea to wait a few weeks before investing in a new investment product. But investors should remember that the 2x Leveraged ETN is likely appropriate only for more aggressive investors willing to accept considerable volatility from their holdings. Don’t be tempted to bet the farm.

Editor’s Note: For additional information on this topic, check out the latest report about Master Limited Partnerships written by Roger Conrad and Elliott Gue.