Last week Roger Conrad and I gave several presentations and participated in a number of panel discussions at the San Francisco Money Show. Not surprisingly, Master Limited Partnerships (MLPs) and MLP Profits were popular topics of discussion.

As always, our conversations and question and answer (Q & A) sessions with subscribers were enlightening. Here’s a rundown of three of the most commonly posed questions and my answers to each.

Question: With the US federal deficit soaring and President Obama likely to raise taxes, what’s the likelihood that MLPs’ tax-advantaged status will be targeted?

No one can honestly tell you with complete certainty that the government won’t target MLPs’ tax-advantaged status. That being said, the near-term risk of such a tax change appears slim.

Recent Congressional action relating to MLPs has tended to expand the sector’s scope, not limit its growth. For example, the Emergency Economic Stabilization Act of 2008 (aka The Bailout) expanded the MLP structure to include forms that transport and store renewable fuels such as ethanol. The insertion of this clause into the bill was broadly bipartisan.

One area that is at risk: carried interest. Although the specifics of carried interest are rather arcane, the effect is that some hedge funds and private equity firms can pay their partners carried interest distributions and have those distributions taxed at capital gains tax rates. This issue came to the attention of lawmakers when the The Blackstone Group (NYSE: BX) and a handful of large private-equity firms went public as partnerships. This is one major reason we’ve rated all of the investment partnerships a Sell in our How They Rate table.

Last year legislation passed the House that would have taxed carried interest payments as ordinary income, but the bill was aimed solely at investment-management partnerships. That law ultimately failed to pass the Senate. However, the President did propose similar legislation as part of his budget.

But the point is somewhat moot, as traditional MLPs don’t pay carried interest. Bottom line: Legislation targeting carried interest is likely to pass, and estimates suggest that it will generate around $24 billion in additional revenues for the government over the next ten years. But these provisions would have no effect on our recommendations in MLP Profits.

Second, the MLP sector is relatively small and likely below the government’s radar. Although carried interest provisions could generate significant additional revenues for the government, recent reports suggest taxing MLPs as corporations would yield no more than $500 million in annual incremental revenues–a drop in the bucket when you consider the size of the US deficit.

Question: Should I hold MLPs in tax-advantaged IRA accounts?

It is not illegal to hold MLPs in an IRA account; however, some of the income you receive from the MLP is unrelated business taxable income (UBTI). UBTI income over $1,000 per year can be subject to tax even though it’s generated by a firm in a tax-free retirement account.

You don’t have to pay taxes related to UBTI directly; this tax would be paid by the company acting as custodian on your IRA, and the custodian would also be forced to file the appropriate forms with the government.  However, the custodian would pass along those costs to you.

Second, because MLPs are already tax-advantaged it makes sense to hold them when possible in a taxable account.  After all, one of the main attractions of MLPs is the tax deferral of return of capital income; you don’t get this advantage inside an IRA account.

There are several MLPs and related investments you can hold in an IRA that do not generate UBTI. In the three MLP Profits model portfolios we hold recommendations appropriate for IRAs: Aggressive Portfolio holding Navios Maritime Partners (NYSE: NMM), Conservative Portfolio holding Kinder Morgan Management (NYSE: KMR) and Growth Portfolio holding Kayne Anderson Energy Fund (NYSE: KYE).

As we explained in the June 18, 2009, issue of MLP Profits, Maritime Rules, although Navios Partners is technically an MLP, it has elected to be taxed as a C-Corporation for US federal income tax purposes. It has no assets in the US, is headquartered in Greece, and earns no revenues in the US. Therefore, it’s not subject to US corporate income taxes. That means its C-Corp tax election has no real impact on its tax liability.

The real advantage here is that Navios Partners doesn’t report distributions on a Form K-1, as do most other partnerships. Instead, the company reports on a standard Form 1099, just like any other company taxed as a corporation.

Kinder Morgan Management (NYSE: KMR) is almost identical to Conservative Holding Kinder Morgan Energy Partners (NYSE: KMP), except distributions are paid in the form of additional units (shares) rather than cash. Such distributions don’t generate UBTI.

Finally, Kayne Anderson Energy is a closed-end fund that invests in a diversified portfolio of MLPs. Like all closed-end funds, Kayne handles all of the tax filling at the fund level and reports distributions to holders on a normal 1099 dividend form.

Question: The industry benchmark Alerian MLP Index has been up as much as 50 percent this year, and MLPs are among the market’s best performing sectors. Is the run-up in the group overdone and are the stocks now overvalued?

Like all indexes that have seen big run-ups, the MLPs will undoubtedly see periodic bouts of profit-taking. In fact, the Alerian Index has pulled back roughly 5 percent from its early August highs.

And late 2008 through early 2009 was certainly a historic buying opportunity for the MLP sector. Yields on even the steadiest and least commodity-sensitive players in the group soared well into the double digits.

But MLPs do not appear overvalued on any historic metric; in fact, the group remains downright cheap. Consider the graph below.


Source: Bloomberg

This chart shows the difference between the yield on Enterprise Products Partners (NYSE: EPD) and the 10-year US Treasury Bond. Positive numbers indicate that Enterprise is paying out a higher yield than the 10-year. I chose Enterprise because it’s among the largest, oldest and most liquid partnerships in our coverage universe.

As you can see, Enterprise typically offers investors a yield roughly 2 to 3 percent above that of the 10-year Treasury note. However, late in 2008 that spread spiked to around 9 percent–an unprecedented level.

As Enterprise’s stock has rallied this year, its dividend yield has fallen and the yield spread relative to the 10-year has dropped to around 4 percent. Although that’s less than half the level that prevailed in late 2008, my graph shows that it’s still offering a higher-then-normal yield advantage to Treasuries. In other words, Enterprise’s chart looks extended, but it’s not expensive by historical norms.

As we’ve noted on a number of occasions, the importance of the normalization in credit markets since the beginning of the year can’t be overstated. MLPs were among the groups worst-hit by the credit crunch. And, in many cases, recent rallies are just returning these stocks to their levels before the collapse of Lehman Brothers almost one year ago.

The correlation between improving debt market conditions and the performance of the MLP stocks is uncanny. Consider this graph.


Source: Bloomberg

The red line on this chart represents the Alerian MLP Total Return Index. The blue line is the inverse of a credit market indicator known as the TED spread. The TED spread plots the difference between the London Inter-bank Offered Rate (LIBOR) and short-term US government bonds.

LIBOR is the interest rate banks charge to lend to one another. When LIBOR spikes relative to government bond rates, it indicates that banks are reluctant to lend to one another.  Bottom line: When the inverse TED spread rises that indicates improving credit market conditions.