It’s official: The benchmark Alerian MLP Index logged the best one-year gain in its 14-year history in 2009, a 77 percent total return. After a rally of that magnitude, it’s only logical for investors to wonder if it’s too late to jump aboard.

But the master limited partnership (MLP) sector isn’t as extended as 2009’s big run-up might suggest. The group logged its worst-ever performance in 2008, the only year in its history the Alerian MLP Index has fallen by more than 10 percent. The big run-up in 2009 was, to a great extent just a reversal of an unprecedented decline in 2008.

As we’ve noted, much of the selloff in late 2008 was due to technical factors rather than fundamentals. Cash-motivated institutional selling in the final months of 2008 weighed heavily on the sector. Many in the group, such as Aggressive Portfolio Holding Linn Energy LLC (NSDQ: LINE), used private investment in public equity (PIPE) deals to raise capital to fund expansion back in 2006 and 2007.

In a PIPE deal, the MLP effectively sells shares directly to a handful of institutional buyers at a slightly discounted price. These shares aren’t registered immediately; the institutional buyer is effectively locked into the stock for some period of time. PIPEs allow MLPs to raise money quickly to fund transactions and can cause less disruption to trading prices in the short term than simply issuing new units to the public.

In 2008, amid a global credit crunch of unprecedented severity, many of the institutional buyers who were heavily involved in the PIPE market were in desperate need of cash. As these shares were registered and became available for sale, the institutions dumped their units. This selling was largely artificial and didn’t reflect deteriorating fundamental conditions, but it was a major factor in depressing unit prices in the final months of 2008.

Another source of institutional selling was closed-end MLP funds. These funds historically have used leverage to help boost their returns in MLPs and offer a higher yield to investors. As credit conditions deteriorated in late 2008 and the prices of many MLPs fell, these closed-end funds began to breach legal limits governing how much debt they can have relative to the value of their portfolios. That forced the closed-end funds to sell MLPs in their portfolios to avoid breaching those limits.

But by early 2009 these forced institutional sellers were largely exhausted. That meant that a major source of artificial selling pressure was removed, helping take the lid off the sector. In fact, as credit markets improved in the first part of 2009, the closed-end fund families began to buy back their positions in MLPs, turning a former headwind into a nice tailwind for the group.

In the words, the 2009 rally in the Alerian MLP Index looks less dramatic when you consider just how depressed the group was in late 2008. And, despite the move, the group isn’t overvalued on any historical measure.

Because MLPs are an income-oriented group, one of the more common valuation metrics is to compare yields to other income-producing investments such as the 10-year Treasury bond or real estate investment trusts (REIT).

Source: Bloomberg

This chart compares the yield for Conservative Portfolio holding Kinder Morgan Energy Partners LP (NYSE: KMP) to the yield on a 10-year US government bond. I chose Kinder for this analysis because it’s one of the largest MLPs and, more importantly, it’s one of the oldest. We have yield data for Kinder going back to the early 1990s.

I’ve overlaid three additional horizontal lines over the chart of the yield spread. The red line shows the average spread over Treasuries for Kinder as far back as there’s data available. As you can see, that level is about 1.83 percent; on average, Kinder has offered investors a yield of about 1.83 percent (183 basis points) more than the 10-year US government bond.

The blue and yellow lines represent two standard deviations above and below that long-term average. “Standard deviation” sounds complex, but it’s just a statistical measure that tells us what would be considered “normal” in terms of Kinder’s spread over Treasuries.

The higher the spread, the lower Kinder’s valuation; Kinder is offering a much higher yield over Treasuries. A spread two standard deviations above the average would imply that Kinder is unusually cheap on this valuation basis. Similarly a spread less than two standard deviations below the average would mean that Kinder’s expensive.

These extremes have only been touched on three occasions since the early 1990s. The most recent and most extreme was late 2008, when Kinder offered a spread of nearly 7 percent over Treasuries, a record high. This occurred during the height of the credit crunch and marked an historic buying opportunity.

As you can see, the spread has since normalized somewhat but is still well above the long-term average. Kinder still looks unusually cheap on this basis, and much of the rally over the past year has simply been a reversal of the unusually depressed valuation for the stock in late 2008. The same basic story is repeated across the entire industry.

Valuations for the Alerian MLP Index also look attractive relative to REITs. The yield on the Dow Jones REIT Index is about 3.7 percent compared to around 7 percent for the Alerian MLP Index, a spread of about 3.25 percent. This is also well above the historical average.

Two additional factors should continue to support the MLPs. First, credit and equity markets have improved markedly. Over the past several months we’ve written extensively about MLPs issuing additional units or selling bonds to raise capital. This is in marked contrast to one year ago, when even companies with the highest credit ratings couldn’t raise money.

This capital is likely to be deployed to make acquisitions or to fund organic expansion projects such as the construction of new pipelines. Acquisitions and organic projects have both historically driven distribution increases for MLPs and rising distributions tends to support prices. After a year of relatively low distribution growth, 2010 is likely to bring a resurgence in distribution hikes.

Second, commodity prices are improving. Many MLPs have little or no exposure to oil and gas prices; however, a few groups benefit from rising energy prices. The first, profiled in the Oct. 9, 2009, issue, is MLPs with exposure to the gathering-and-processing business.

The second comprises the upstream MLPs that produce oil and/or natural gas. G&P, in particular, was a drag to many MLPs’ results in 2009 but is quickly becoming a tailwind. Processing margins continue to improve, and drilling activity is picking up somewhat in some US gas plays such as the Haynesville Shale.

Interest Rates

Of course, there are also risks. Traditionally, periods of rising interest rates tend to be a negative for income-oriented groups. There are a number of reasons that’s the case.

First, bonds tend to compete with other income-producing assets for investors’ capital. Over the past year, with US government bond yields hovering near historic lows, there hasn’t been much competition.

Investors haven’t been able to earn a return in government bonds that keeps pace with inflation, so they’ve turned to groups like the MLPs that offer higher yields and some potential for capital appreciation. If the yield on government bonds rises, it would tend to make them a more attractive investment for yield-hungry investors.

A second factor is that rising interest rates means that it’s becoming more expensive to raise capital. Because MLPs use debt markets to fund growth, that spells lower returns and makes fewer projects economically attractive.

But as we noted above, even though bond yields are rising MLPs still offer an unusually high and attractive spread over the one-year government bond. Even if interest rates continue to rise, there’s significant scope for this spread to contract to more average levels. MLPs still look extremely attractive relative to bonds.

In addition, although rising rates means higher costs of capital, many MLPs have raised considerable war chests this year at ultra-low rates. They’ll have little need to tap markets again in 2010. And even if rates were to rise from current levels MLPs costs of debt capital would remain near historic lows.

Source: Bloomberg

This table shows the return on the Alerian MLP Index going back to the mid 1990s. In each year I also showed the path of the fed funds rate and the 10-year US government bond.

Falling interest rates tend to support MLPs, but the index has offered solid returns on several occasions when rates were rising. For example, the Fed was hiking rates in 2005 and 2006, and the yield on 10-year bonds also rose, yet the Alerian MLP Index produced a positive return in 2005 and had one of its best years ever in 2006.

One reason for this is that MLPs have traditionally offered strong distribution growth. In years like 2006, when the Fed’s raised rates, it’s typically meant that the economy is strong and that MLPs are finding plenty of opportunities for expansion. This is a recipe for strong distribution growth; growth in payouts helped attract investors to MLPs in 2006 even though rates were rising.

Taxation

Roger and I are often asked if there’s a potential for the Obama administration to change the tax laws governing MLPs such that they lose their significant tax-deferral advantages. Although there’s no such thing as complete certainty in politics, there’s no sign of a change on the horizon.

Unfortunately, there is a great deal of misinformation published on the Internet and in print media concerning MLP taxation. Back in 2007 a series of articles published in major media outlets claimed that Congress was working on legislation to end the MLP tax advantage.

The same rumors have cropped up again lately because of an editorial published recently in The Wall Street Journal and quoted elsewhere. In both cases, these articles have been referring to a complex tax issue known as “carried interest.” The bottom line is that the energy-focused MLPs we recommend would not be adversely affected by the proposed tax changes and, in fact, may benefit.

Here’s the real story.

On Dec. 9, 20009, the US House of Representatives passed The Tax Extenders Act of 2009 (HR 4213). The bill extends certain tax benefits to individuals and businesses but includes language that would mean that all carried interest income is taxed at ordinary income tax rates rather than lower capital gains rates.

The same basic language was included in the Treasury Dept’s Green Book, a document that explains at great length the Obama administration’s tax proposals for the year ahead.

Carried interest is a form of compensation paid to a partnership’s managers in exchange for their services. For the publicly traded MLPs, carried interest includes the incentive distribution rights (IDR) the limited partners pay to their general partners (GP). We’ve explained the GP-LP relationship in prior issues, including in the Nov. 20, 2009, Viewpoint, Faster Growing Income.

Here’s where it gets a bit complicated. Carried interest paid to general partners represents a share in the income produced by the partnership and is taxed accordingly. Thus, if that carried interest is generated by buying and selling financial assets such as stocks and bonds, it could represent capital gains rather than ordinary income. Under the current law, those managers receiving carried interest earned through capital gains would be taxed at the lower capital gains tax rate.

This doesn’t apply to the energy MLPs. Energy MLPs represent operating businesses; the carried interest income they generate isn’t capital gains and has always been taxed at ordinary income tax rates. Managers don’t pay the lower capital gains tax rates on their IDRs at the current time, so this law wouldn’t affect their taxation one bit.

Note that this has nothing at all to do with those of us who are MLP unitholders, owning the units of the MLPs we recommend. As MLP unitholders we don’t receive carried interest income as part of our regular quarterly distributions, so this doesn’t represent a change to the way we’re taxed.

There is one exception: the publicly traded MLPs of companies involved in the private equity and investment management businesses. That list includes AllianceBernstein (NYSE: AB), Fortress Investment Group (NYSE: FIG), Icahn Enterprises (NYSE: IEP), KKR Financial Holdings (NYSE: KKR), Lazard (NYSE: LAZ), and Och-Ziff Capital Management (NYSE: OZM). Because these firms do generate carried interest from financial activities, their managers have been taxed at lower capital gains rates on some of the carried interest they receive. These managers could face a higher tax bill if the law is passed.

To make matters worse, the House legislation includes a provision that explicitly says that publicly traded partnerships that provide investment management services will no longer be eligible for partnership tax treatment; these firms would no longer be able to be taxed like MLPs. No new investment management partnerships would be allowed to list, and those already in existence would be given 10 years to change their structure.

Since we started MLP Profits we’ve repeatedly noted that these financial partnerships are in the Obama administration’s crosshairs and that the risk of this sort of legislation loomed. That’s why we’ve rated all of these partnerships “Sell” in our How They Rate table.

The current consensus in Washington is that there aren’t enough votes in the Senate to pass this particular legislation. But the carried interest provision could be reintroduced in another bill if it doesn’t pass this time around. This is another chance to get out of the investment management partnerships if you haven’t already.

There are two additional points worth noting. First, the Obama administration has proposed raising taxes on dividend income. Because MLPs don’t pay dividends, such a change would actually make them more attractive to investors because they’d become even more tax-advantaged relative to dividend paying stocks.