Master limited partnerships, or MLPs, have performed poorly in the past two months, giving back the majority of the gains they achieved in the October-March interval.
The largest exchanged-traded fund tracking MLPs — the ALPS Alerian MLP ETF (NYSE:AMLP) — has lost 6.66% since March 1, underperforming the -3.60% return of the SPDR S&P 500 ETF (NYSE:SPY) during the same interval. This shortfall stands in contrast to MLPs’ strong showing in 2011, when AMLP gained 8.33%, outpacing the gain of 1.89% in SPY. The question now is: Does this downturn make MLPs a buy, or is it still too early?
First, a quick review of the factors weighing on the sector:
MLPs initially began to lose ground when U.S. Treasury yields spiked during March, but the subsequent retracement in government bonds — which should have been a positive for the sector — has been overshadowed by concerns about how the weakness in economic growth could weigh on the demand for energy. The political wrangling over the Keystone Pipeline also hasn’t helped matters. While these issues have grabbed headlines, the real problem is more likely that the sector had become too popular amid the search for higher-yielding investment options.
In recent months, AMLP reached $3 billion in assets for the first time, a new ETF — Global X MLP ETF (NYSE:MLPA) — hit the market, and other new products were announced. The result was an increase in valuations and a collapse in yields to historical lows, which left MLPs vulnerable coming into the latest wave of concern about Europe.
Notably, MLPs aren’t alone: Other “bond alternatives,” such as preferred stocks, convertible bonds, and REITs have taken it on the chin in recent weeks as investors have sought to cut risk.
Unfortunately, this may have come as a surprise to investors who bought into the storyline about the “safety” of MLPs. Do MLPs deserve that reputation?
Click to Enlarge A look at the 10-year chart of Kinder Morgan Energy Partners LP (NYSE:KMP) shows no fewer than seven occasions in which investors had to absorb double-digit losses. So MLPs indeed are risky — something investors new to the sector may be starting to appreciate.
The question now is whether MLPs have fallen far enough to warrant attention.
By one important measure — yield — the sector has certainly become more attractive after the recent downturn. Back on January 31, I warned that MLP yields were too low relative to both their own history and to other asset classes for the rally to continue much further.
Today, yields stand somewhat higher compared with the early March peak, which takes some of the pressure off. Also, Barron’s reports that the yield spread between the Alerian MLP Index and the 10-year Treasury “gapped a whopping 49 bps to close the week at 495 bps, which marks the widest spread since a 505 bps spread on October 5, 2011.” (Bps are basis points, so 495 bps = 4.95 percentage points.)
Despite this, absolute yields still are not particularly attractive on a historical basis. The chart below, which shows the 10-year yield history for Plains All American Pipeline LP (NYSE:PAA) is representative of the broader group. While PAA’s yield has indeed become more attractive, it still has a long way to go to revert to its historical average:
Investors therefore need to take with a grain of salt the many recent articles promoting MLPs. The sector is becoming more interesting, and it deserves a spot on the shopping lists of income-oriented investors if this downturn continues.
At the same time, however, it’s also become clear that one element of the current flight to quality is an evacuation from the higher-income asset classes. Until we see more clarity from Europe and a stabilization of performance for REITs, high-yield bonds and the like, tread carefully with MLPs.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.
