The Alerian MLP Index posted an 11.2 percent total return in the third quarter and is up an impressive 24.3 percent year to date, trouncing the S&P 500’s 3.9 percent gain in the first three quarters of 2010.

Better yet, our model Portfolios also turned in a strong third-quarter performance: The Conservative Portfolio was up 12 percent; the Growth Portfolio gained 7.3 percent; and the Aggressive Growth allocation soared 16.3 percent.

Such strength naturally leads to questions about whether MLPs will continue to rally. Some pundits in the media and financial press continue to stoke these fears, publishing articles stating that MLPs are overvalued or that the group’s distributions are threatened in some way. I’ve read dozens of articles following the same attention-getting formula over the past five years.

Here’s a dose of reality.

As Roger S. Conrad explained in the last issue of MLP Profits, MLPs: How They Rate, technical and emotional factors have contributed to the group’s outstanding performance this year. The potential for higher taxes on dividends has piqued interest in the tax advantages offered by MLPs, while the launch of a number of MLP-focused exchange-traded and closed-end funds has also bolstered unit prices. 

But the current rally doesn’t appear to be a speculative bubble. MLP valuations aren’t high by any relevant historical context, and distributions aren’t under threat.

Like every security class, MLPs suffer periodic run-ups and selloffs. In 2010 the group has suffered two broad corrections of more than 10 percent.

Here’s a look at three factors that support continued upside for energy-focused MLPs.

It’s Relative

MLPs have outperformed the broader market over just about any time frame you’d care to examine. Over the past 12 months, for example, the S&P 500 has returned a healthy 10.1 percent, while the Alerian MLP Index has soared 42 percent. The group’s track record over the past decade is equally impressive: MLPs posted an annualized gain of 18.8 percent, whereas investors who bought the S&P 500 would have suffered a loss.  

But strong market performance doesn’t mean a security class is necessarily overvalued. High yields and consistent distribution growth justify the gains posted by MLPs over the long term.

Industry heavyweight Enterprise Products Partners LP, for example, has boosted its payout by nearly 122 percent since the third quarter of 2000. Steadily growing cash flow and distributions, not investors’ irrational exuberance, are behind the stock’s strong performance.

Near-term valuation concerns are a bit more plausible. The recent rally has pushed the Alerian MLP Index’s average yield to less than 5.9 percent, compared to 7 to 8 percent at the end of 2009 and a five-year average of more than 7 percent. Some pundits have argued that declining yields on many major MLPs suggest that the group is too expensive.

Though elegant in its simplicity, this argument doesn’t hold water because it fails to account for a dramatically different interest-rate environment.

The Federal Reserve has slashed interest rates to zero and likely will initiate another round of quantitative easing (QE) that involves purchasing long-term government bonds and, quite possibly, other assets such as mortgage-backed securities. Meanwhile, the Bank of Japan has already announced that it will purchase government and corporate bonds, as well as shares of Japanese real estate investment trusts.

QE drives up the price of long-term bonds and pushes down yields. In addition, the policy injects cash into the banking system. The theory is that lower long-term interest rates and more liquidity will stimulate lending and credit, the lifeblood of economic growth. Regardless of the outcome of QE2, one thing is clear: Low yields on most bonds and savings products practically guarantee that you’ll lose money on an inflation-adjusted basis.

Five years ago the average yield on a one-year certificate of deposit (CD) was 4 to 5 percent, and 10-year US government bonds yielded well over 4 percent. Today, you’d be lucky to find a CD that pays more than 1 percent, while 10-year Treasury notes yield a paltry 2.5 percent.

In this low-yield world, the Alerian MLP Index’s average payout of 5.9 percent is downright generous.

A more relevant measure of valuation is the spread between the yield offered by an MLP and the yield on the 10-year Treasury note.

Source: Bloomberg

This graph tracks the yield offered by units of Enterprise Products Partners compared to the yield on a 10-year Treasury note.  

Although Enterprise Products Partners’ current yield of 5.6 percent is considerably less than its 10-year average, the spread relative to the 10-year Treasury note stands at more than 3 percent–comfortably above a long-term average of 2.7 percent.

Broadly speaking, MLPs also offer superior yields to traditional income-oriented groups. For example, the current yield on the Bloomberg Diversified REIT Index is 3.73 percent, more than 200 basis points (2 percent) less than the Alerian MLP Index.

Distribution Growth

It’s a mistake to focus solely on yields and ignore the potential for distribution growth.

When you buy a standard corporate or government bond, your periodic interest payments never change. Though lower in the capital structure, an income-paying common stock offers the potential for dividend growth. Traditionally, this is one of the biggest advantages offered by MLPs, many of which have a long history of hiking their quarterly payouts.

For example, not only has Enterprise Products Partners raised its distribution 34 times since it went public in 1998, but last month the MLP also announced its 25th consecutive quarterly increase. If you invested $10,000 in Enterprise at the beginning of 2000, you would now be earning $2,527 in annualized income from distributions, a whopping 25 percent return on your initial investment. And that’s on top of the significant capital gains you would have racked up in the ensuing decade.

Investors are willing to pay more for MLPs that have the scope to grow their distributions in coming quarters. We keep our eyes peeled for names that have major new projects slated to come online, are pursuing acquisitions that would be accretive to cash flow, or could benefit from potential drop-down transactions from its general partner. I discussed drop-down deals at length in IPOs for Growth.

Out of the 50 MLPs in the Alerian MLP Index, 11 have announced their fourth-quarter distributions. Nine of these partnerships will boost their payouts, while the other two plan to maintain their distributions. If this pattern holds, it will represent a notable pick-up in distribution growth from recent quarters, both in terms of the percentage of MLPs that are boosting their payouts and the degree to which their distributions are increasing. 

Several factors are behind this robust distribution growth.

For one, the financial crisis locked many MLPs out of the credit markets, while a free-falling stock market made it next to impossible to raise cash by issuing new units. At the time, most MLPs focused on hoarding cash rather than pursuing acquisitions or new growth projects, temporarily stunting distribution growth.

But by mid-2009 credit and equities markets had improved to the point that MLPs were able to issue new units, sell bonds or negotiate new lines of credit. Easier financing renewed MLPs’ interest in new projects and acquisitions. As cash flow from these endeavors hit the bottom line, distribution growth has picked up once again.

And MLPs continue to raise inexpensive capital. Since the beginning of August, six of our recommended partnerships have issued $3 billion worth of new bonds. The table below lists the yield to maturity for each of these issues.

Source: Bloomberg

As you can see, the two MLPs with the highest credit ratings have issued bonds at remarkably low rates. A five-year issue from DCP Midstream Partners LP (NYSE: DPM) yields less than 3 percent, compared to a yield of roughly 1.15 percent offered by five-year US Treasury notes. Meanwhile, a $300 million issue from investment-grade Magellan Midstream Partners LP (NYSE: MMP) yields less than 3.9 percent. A 10-year Treasury note yields 2.51 percent.

Lower-rated MLPs have also locked in long-term financing at attractive rates. Despite a B credit rating from Standard & Poor’s, Linn Energy LLC (NSDQ: LINE) is paying less than 7.5 percent on $1 billion worth of bonds maturing in 2021. In mid-April Linn Energy issued $1.3 billion in five-year bonds with a yield to maturity of almost 9 percent.

In six months Linn Energy has gone from paying 8.9 percent on five-year bonds to less than 7.5 percent on bonds maturing in more than 10 years.

If the credit crunch was a trying period for MLPs, the current funding environment is a welcome relief. A few years ago, only the largest MLPs with investment-grade credit ratings issued debt. Smaller MLPs relied on credit lines negotiated with banking groups and private placements of stock with hedge funds and other institutional investors.

The drawbacks of these funding options became abundantly clear during the financial crisis, when banks reduced the size of credit lines that were up for renegotiation. Private-placement deals also soured as leveraged institutional investors dumped stocks to raise capital. These distressed sales put artificial pressure on even the strongest MLPs in fall 2008.

Now smaller and less highly rated partnerships have ample access to long-term debt capital.

With ready access to inexpensive capital, MLPs have no trouble funding new projects that boost cash flow and set the table for higher distributions.

Industry Fundamentals

Some critics of energy-focused MLPs argue that fundamentals are deteriorating, particularly in business lines related to natural gas. These pieces usually cite depressed natural gas prices and question whether output from unconventional gas plays is sustainable. Evidence of weak US energy demand is also trotted out as a bad sign for MLPs.  

Albeit scary, none of these arguments hold water, even under the most casual examination.

In the Sept. 7, 2010, issue of MLP Profits, The Natural Gas Equation, we covered these cavils at great length. Those who question the sustainability of US shale plays would do well to note the huge investments that ExxonMobil Corp (NYSE: XOM) and other energy giants have made in this space. If these fields didn’t offer long-term upside, you can bet that money would be flowing into other developments.

In the first half of 2010, $21 billion in new investment flowed into developing and producing US shale plays through a string of acquisitions and joint ventures. A great deal of new infrastructure will be required to ensure that these deals pay off.

The latest example: China National Offshore Oil Company, or CNOOC (HK: 833, NYSE: CEO) has agreed to pay a total of more than USD2 billion to Chesapeake Energy Corp (NYSE: CHK) for a 33 percent stake in the outfit’s acreage in the Eagle Ford Shale. One of the nation’s hottest shale plays, the Eagle Ford yields a combination of oil, natural gas and natural gas liquids (NGL). Enterprise Products Partners has projects underway that will make the Conservative Portfolio bellwether one of the leading infrastructure operators in the region.

Skeptics should also note that MLPs leave little to chance when building new assets. Before breaking ground on new projects, partnerships hold open seasons to gauge interest and obtain written contracts from producers that guarantee a minimum level of cash flow.

Concerns that the US might end up with a glut of excess pipeline and processing capacity are ludicrous.

And the fundamentals governing natural gas processing have improved since we penned The Natural Gas Equation.

Source: Bloomberg

This graph compares the price of a barrel of mixed NGLs to the price of a barrel of West Texas Intermediate crude oil. Currently, the NGLs barrel is worth roughly 59 percent of the value of a barrel of crude, dead on the long-term average of 60 percent.

Many petrochemicals can be produced either from crude oil or NGLs; the rising US availability of NGLs and high crude oil prices has improved the cost competitiveness of US chemicals producers. Some firms have announced plans to open new facilities or re-open plants that were shuttered during the recession to meet strong global demand for petrochemicals.

As we explained in the Sept. 7 issue, strong NGL demand and weak natural gas prices is great news for MLPs that process and fractionate NGLs. Expect Enterprise Products Partners and Targa Resource Partners LP (NYSE: NGLS) to share a positive outlook for these business lines when they report third-quarter results.

Finally, the suggestion that US demand for natural gas is weak has little basis in reality. The truth is that weak pricing is more a function of too much supply. As we pointed out in The Natural Gas Equation, demand for natural gas among industrials and electric utilities is actually stronger than usual. Anyone who writes that US gas demand is weak isn’t doing their homework or checking their facts.  

Portfolio Updates

The buy targets on our recommended stocks are conservative, and we only raise them if the partnership’s underlying fundamentals warrant a higher price. In keeping with this principle, we’re raising our targets on a handful of recommendations to reflect business improvements and recent distribution hikes.

As always, we caution readers against buying any Portfolio holding that trades above our buy target; instead, be patient and wait for a dip to pull the trigger–overpaying for a good company can eat into returns.

We will continue to review our buy targets as MLPs report earnings over the next month.

Conservative Portfolio bellwether Kinder Morgan Energy Partners LP (NYSE: KMP) has an attractive slate of growth projects underway, including a new pipeline that would transport NGLs from Appalachia’s Marcellus Shale to the Midwest and Canada. In addition, Kinder Morgan Energy Partners’ CO₂ business should benefit from higher oil prices.

We expect the MLP to announce yet another increase in its quarterly distribution, likely from $1.09 to roughly $1.11. Management should also provide updates on projects that are underway and those still being evaluated. We’re boosting our buy target on Kinder Morgan Energy Partners LP from 70 to 73.

Fellow Conservative Portfolio holding Enterprise Products Partners LP has raised its quarterly payout to $0.5825, up from $0.5525 in the same quarter one year ago. Enterprise Products Partners LP’s exposure to the red-hot Eagle Ford play and its NGL business justify a new buy target of 42.

Growth Portfolio holding Energy Transfer Partners LP (NYSE: ETP) has lagged many of our picks since it issued units back in August. But we like the company’s planned growth projects, including two new pipelines in the Eagle Ford Shale–the Dos Hermanas Pipeline, scheduled for completion in December, and the Chisolm Pipeline, slated to begin operation in the second quarter of 2011.

Growth-oriented investors should also consider buying the company’s general partner, Energy Transfer Equity (NYSE: ETE) instead of the MLP. We explained this investment in the Sept. 17, 2010, issue of MLP Profits, General Partners for Sale.

Suffice it to say that an investment in Energy Transfer Equity is a play on two of our favorite MLPs. In addition to Energy Transfer Partners’ general partner, Energy Transfer Equity also owns the general partner of Aggressive Portfolio holding Regency Energy Partners LP (NSDQ: RGNC). 

We’re boosting our target on Energy Transfer Partners LP to 52. Energy Transfer Equity rates a buy under 42.

Targa Resource Partners LP recently announced a third-quarter distribution of $0.5375, up from $0.5275 last quarter and $0.5175 a year ago. This marks the second time the MLP has hiked its quarterly distribution after holding its payout steady from November 2008 to May 2010.

Offering exposure to strong gas-processing economics and the NGL market, Targa Resource Partners LP is a buy up to 31.

Aggressive Portfolio recommendation Linn Energy LLC hasn’t raised its distribution since its payout for the fourth quarter of 2007. The MLP has raised billions of dollars in new capital this year through bond and new unit issues and has used the proceeds for a series of aggressive acquisitions.

Look for these deals–especially its purchases of oil-producing properties–to justify a distribution increase as soon as this quarter. We’re raising our target in Linn Energy LLC from 30 to 33.

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.