Will rising rates push MLP investors to traditional bond instruments?

Financial market participants, economists, home owners, central bankers, and everyday people have all been discussing one major financial question for the past few years. It has consumed gobs of press ink, hours of pundit discussions, acres of blog posts, and untold speculative chatter. We were told alternatively to not worry about it, to prepare prudently for it, or to make plans for our impending doom when and if it happened. What was it that occasioned all this angst? A rise in U.S. interest rates. It seems for the past few years the world has been continuously debating when interest rates on U.S. Treasuries would rise. Rates finally did rise significantly in the latter part of the second quarter, with the 10-year U.S. Treasury yield rising from a low of 1.64% in early May to a high of 2.59% on June 25th before ending the quarter at 2.48%. The increase in Treasury yields prompted sharp responses throughout the fixed income market; for example, mortgage rates rose the most in one week since 1980 just after the Fed comments. While still low by historic standards, long Treasuries ended the quarter near the highest levels in almost two years. Rates had been rising modestly since early May but accelerated after Fed President Ben Bernanke announced in mid-June that the labor market was a bit better than previously thought and that the Fed might start scaling back its buying of bonds sooner than previously announced. No matter that Bernanke hedged his comments with many caveats; his words obviously touched a nerve with investors. Government, corporate, mortgage, and high yield bonds sold off fairly dramatically after his announcement. Investors have been worrying for a long time about the potential of rising interest rates shifting investor interest from MLPs and MLP-related securities to traditional fixed income instruments. Like Pavlov's dogs responding to stimuli, some investors instinctively sold off MLPs in response to rising rates. The Alerian MLP Index(1), which had risen modestly early in the quarter, fell 8% from a peak in late May to a trough in late June. But then a funny thing happened. Treasuries leveled off and then retreated a bit at the end of June. This appears to have allowed investors to refocus on fundamentals, resulting in MLPs staging a nice rally in the last week of the quarter regaining a good bit of ground that they had lost. When all the dust settled, the Alerian MLP index returned 2.0% in the quarter, bringing its year-to-date return to 22.1%. We believe that the long term prospects of energy infrastructure assets remain attractive, especially in an environment where numerous growth projects offer visible paths to distribution increases; however, this recent rise in interest rates, which took so many “experts” by surprise, is a reminder of the uncertain nature of the financial markets. A further rise in interest rates, or some other unforecastable event, could again negatively impact MLPs in the short run. Unfortunately these short run perturbations are inevitable and we endeavor to not overreact to them. While we remain vigilant to the risks to investing in MLPs and MLP-related securities in the short run, we continue to be guided by our assessment of long term total returns of individual companies. During the second quarter of 2103, MLP managements announced a number of new investments, bringing estimated capital expenditure for new growth projects to $29 billion for 2013, the highest annual amount of organic capital projects on record. Additionally a number of MLPs and MLP-related securities announced significant purchases of assets from associated companies or third parties. MLPs and MLP-related securities maintained their record pace of capital raising by floating over $6 billion in equity. A significant amount of debt capital was also raised as both investment grade and non-investment grade MLPs and MLP-related securities continued to take advantage of record low interest rates to lock in long term financing at favorable terms. Companies issued low cost debt mainly to fund construction projects and to refinance higher cost debt, both of which could increase the available cash flow for distribution going forward. The MLP sector has been able to raise equity capital at such a brisk pace due to the expansion of MLP dedicated funds. In addition to closed-end funds, which have been a major source of new investor capital into the MLP space for many years, open-end funds, ETNs and ETFs have become a significant source of new investor capital in the past two years, and this past quarter was no exception. Open-end mutual funds focusing on MLPs are the newest and fastest growing source of funds to the sector. Analysts estimate that money in MLP open-ended mutual funds has grown from $5.0 billion at the beginning of the year to $9.1 billion at the end of May, an annualized growth rate of 140%. While this growth is dramatic, many of these new investment vehicles are relatively young and a small fraction of the total sector market cap. Recently it was estimated that investment products linked to MLPs represent approximately 7% of the total MLP market cap; by comparison, it is estimated that REIT investment products represent approximately 27% of the REIT universe. It appears that these new investment vehicles are still in the early innings of raising investor funds and may be significant source of demand for years to come. Underlying this need for capital is the requirement for infrastructure to develop new hydrocarbon basins. As we have noted previously, dramatic increases in production of oil, gas, and natural gas liquids from North America have been unleashed by new technologies improving recoveries from previously uneconomic shale formations. U.S. oil production rose by 1 million barrels a day in 2012, the biggest annual gain in the nation's history, according to a recent report by BP. Natural gas production in the U.S. rose the fastest of any major region last year, and the U.S. remains the top producer in the world. The quantity and quality of potential investment opportunities currently facing MLPs reminds us of a quote by Yogi Berra about a nice hotel, “The towels were so thick there I could hardly close my suitcase.” In our opinion, the current abundance of new hydrocarbons from different geographies has created many potentially good investment opportunities for MLPs to choose from. Announcements of large potential projects just keep coming. Williams and Boardwalk Pipelines finalized an agreement to develop the Bluegrass Pipeline project to bring NGLs from the Marcellus and Utica shale basins to petrochemical and export markets on the Gulf Coast. Enterprise Products also announced plans to expand and repurpose parts of the ATEX Express Pipeline to bring Northeast NGLs to their hub at Mt. Belvieu, TX. Energy Transfer Partners and Enbridge Partners started signing up producers to transport crude oil from the Midwest to refining markets along the Mississippi and Louisiana Gulf Coast on the Eastern Gulf Crude Access Pipeline. There are a number of proposals for LNG export terminals awaiting approval from the Department of Energy, which, if approved, would occasion another set of new project announcements by various MLPs. Florida Power and Light is currently entertaining proposals from a number of MLPs to build a multi-billion dollar natural gas pipeline to supply its power plants. The acquisition market also remains robust. Wells Fargo estimates that year-to-date MLPs and MLP-related securities have announced $20.9 billion of acquisitions. During the quarter Spectra Energy Partners announced that it would purchase all of its parent Spectra Energy's U.S. gas transmission and storage assets by the end of the year (this is in addition to its purchase of a 50% interest in the Express-Platte crude oil system earlier this year); TC PipeLines also announced the purchase of $1 billion in natural gas pipelines from its parent, TransCanada Corp; Inergy, LP announced it would spin off its shares of Inergy Midstream, LP and merge it with Crestwood Midstream Partners; and a number of smaller deals were announced during the quarter. We continue to believe that a major change in the tax status of MLPs is not likely to occur any time soon. Our outlook is based on discussions with analysts and political figures who have rated the prospects of a general tax reform from this Congress to be low. One interesting political development is a proposal by a bipartisan group of Senators and Representatives to expand the MLP business structure to renewable energy companies. Called the Master Limited Partnership Parity Act, and introduced in both the House and Senate, it would encourage the investment in solar, wind, and biomass power projects and infrastructure by reducing the cost of capital through the MLP structure. As yet, these bills are awaiting costs estimates by the Congressional Research Service and could be considered later this year. While we have no real information to base an opinion about whether this development, if passed, will create attractive investment opportunities, we do view it positively that Congress is interested in expanding the MLP structure rather than curtailing or eliminating it. Nonetheless, the merry-go-round of Washington politics is a never ending puzzle and we continue to closely monitor the administration and Congress for signs that MLPs could be affected by some of the various tax proposals being discussed; however, we have not seen any specific developments of concern. As we look into the future, we continue to believe that over the next five years the midstream energy infrastructure markets should generate positive annual returns through a combination of yield and price appreciation. Valuations, while not as attractive as they were at the beginning of the year, we believe are still very attractive relative to most other asset classes. Given the rise of interest rates in the past quarter, spreads of MLP yields versus Treasuries and corporate bonds compressed back from unusually high levels but still remain above average. Spreads of MLP yields versus REITs and high yield bonds are also still above average. We think the outlook for distribution growth is also very healthy, driven by accretive capital projects and the availability of asset acquisitions. So despite the sharp run up this year, we think the outlook for total returns in the low double digits for the next twelve months is still intact. While rates on fixed income, REITs, and utility securities rose in the quarter, they are still absolutely low in a relative and historic context. In contrast, while MLP yields are lower than before, we believe they still remain attractive for the yield oriented investor. We believe that the demographic trend of a growing population retiring and expecting to live off their investments may result in a wider investor base seeking out the income generation potential of the MLP asset class. We also believe the growth and distribution that MLPs may offer is a further attraction to those seeking to stay ahead of inflation and potentially earn positive real returns as well as seeking a buffer to rising rates in the long term. David Chiaro is co-head of MLP investment strategies at Eagle Global Advisors and co-portfolio manager of the Eagle MLP Strategy Fund.