MLP ETFs: A Solid Play In Lieu Of T-Notes

March 19, 2013

MLP ETFs continue to gain traction at a time of ultra-low yields and an overstretched bond market.

 

More than a fifth of all the exchange-traded products launched so far in 2013 have been focused on master limited partnerships (MLPs), as investors continue to pour assets into a segment that promises solid income potential at a time when many bond yields look paltry and bond prices look stretched.

Two MLP ETFs and two MLP ETNs have come to market this year, beginning with the Barclays-backed iPath S&P MLP ETN (NYSEArca: IMLP) on Jan. 4. Since then, the Global X Junior MLP ETF (NYSEArca: MLPJ), the Yorkville High Income Infrastructure MLP ETF (NYSEArca: YMLI) and another Barclays-based ETN, the Barclays ETN+ Select MLP ETN (NYSEArca: ATMP), have followed.

The latest additions entered a space that’s anchored by the veteran JP Morgan Alerian MLP ETN (NYSEArca: AMJ), which was first launched by Bear Stearns then rebranded four years ago after Bear’s demise. The new securities further slice and dice an asset class that’s now accessible to ETF investors via 17 exchange-traded products, the majority of them ETNs. Their annual expense ratios range from 0.45 to 1.45 percent.

MLPs are U.S. energy assets that were created in the mid-1980s by an act of Congress to encourage private investment in U.S. energy infrastructure, and have been used by many as safety investments, much like an allocation to U.S. Treasurys. A big part of that is that MLPs are known to deliver yields in excess of 6 percent, while yields on 10-year Treasury notes—while rising in recent months—are still around just 2.5 percent.

Most, if not all, MLPs have toll-like revenues from things such as pipelines, meaning they aren’t affected by swings in oil and natural gas prices. The MLP class has grown at 25 percent rates in the past decade and now spans assets valued at $375 billion, according to estimates in the industry. Given expanding energy production in North America, that growth is likely to continue strongly, industry sources say.

They’re essentially partnerships that trade on a stock exchange like a corporation, but without federal income tax liability at the entity level. MLPs are exempt from paying corporate income tax because they derive the majority of their income from energy-related activities.

At the end of the day, they are “pass through” vehicles, much like REITs, and as such, they don’t pay corporate income taxes, which allows them to pass through higher yields to investors. Because of that feature, they have grown in popularity with investors who are looking for income at a time when low-interest-rate policies have compressed yields in the more traditional fixed-income space, notably Treasurys.

It’s worth noting that MLP ETFs have different tax treatment than MLP ETNs, the main difference being that ETFs are C-corporations and ETNs are corporate debt obligations.

That means ETFs generally do a better job at passing through tax-efficient income than an ETN would. That said, ETNs are best at replicating the total return of the underlying partnerships because there’s no corporate tax drag in the note structure.

The downside of ETNs is also the exposure to issuer credit risk, while ETFs come with the drawback that a C-corporation has to pay corporate income taxes, and that takes a bite out of total returns.


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