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THE NEXT BIG INCOME INVESTMENT
by Elliott H.
Gue
Editor, The Energy
Letter
November 15, 2006
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A rollicking, five-year
party on Canada’s stock markets recently came to an abrupt end with an
announcement that the nine-month-old Conservative government (Tories)
was clamping down on income trusts. The trusts had become too much of a good thing, making up over 11 percent of the Toronto exchange’s market value. Once confined to the real estate and energy sectors, they’ve ballooned over the last five years into an instrument that regulators could no longer ignore. Under the new rules, future trusts will be subject to the same tax rates as traditional companies. Existing trusts will have a transition period to soften the blow. Where Do Income Investors Go Now? Yields on 10-year US Treasury bonds are currently nothing to write home about. Meanwhile, the Philadelphia Utility Index yields just 3.5 percent and the Bloomberg Real Estate Investment Trust (REIT) Index just 5 percent. Utilities, REITs and bonds are the go-to sectors for investors looking for income, but none are offering high yields right now. Fortunately, the energy sector offers an alternative. Publicly traded master limited partnerships (MLPs) can hand investors high tax-advantaged yields, outstanding growth opportunities and relatively low exposure to volatile oil and gas prices. MLPs are traded right on the major US exchanges just like common stocks. And the better-placed MLPS offer annual distribution growth (payout increases) of 5 to 10 percent on top of yields between 6 and 8 percent. Better still, changes to the US tax code are allowing mutual funds and other institutional investors to more freely buy MLPs. This is a whole new class of investor, previously shut out of the group. As this institutional capital begins to find its way into MLPs, the buying pressure will push up prices for the best-placed partnerships. In short, the bull market in MLPs is just getting started and this is my top slow-but-steady income idea for the next few years. I already hold four MLPs in the income-oriented Proven Reserves section of The Energy Strategist portfolio: All remain buys at current levels. I'm adding another MLP cash cow to the Proven Reserves this week, and I've picked up coverage of several additional MLPs in How They Rate--please see this table (click the “Portfolios” tab on the Web site) for my latest advice. Let's take a few moments to look at MLPs and their advantages in more depth. An MLP Primer MLPs are partnerships that trade directly on the major exchanges just like common stocks. Most of the MLPs I follow trade on the New York Stock Exchange and can be purchased easily through any discount or full-service broker at the same commissions you'd pay to buy any stock. Just like common stocks, MLPs offer limited liability for unit-holders (shareholders). That means you're not responsible for any charges or losses beyond your investment in the MLP. MLPs raise capital by issuing units--the rough equivalent of shares in a common stock--and are permitted by US law to own certain specific types of assets. Pipelines, gas processing facilities, coal properties and production platforms are just four of the most common assets owned in MLPs. Most MLPs are owned jointly by one or many general partners (GPs) and limited partners (LPs), the unit-holders. The GP is responsible for the day-to-day operation and management of the MLP's assets. The GP makes all decisions related to acquisitions of new assets and sales of existing assets. Normally, the GP also owns a small stake in the MLP and receives what's known as an incentive distribution for managing the partnership's assets. Incentive distributions are, in almost all cases, based on a pre-set tiered system--the more money the GP generates to pay out to unit-holders, the higher their take of those cash flows. The idea is that this incentivizes the GP to make more distributable cash for unit-holders--the more they make for the LP, the more they get to keep as an incentive distribution. Some GPs are themselves publicly traded partnerships. But in most cases, the GP is a normal corporation. Some of the largest firms in the energy business such as Williams, Teekay Shipping and Valero act as GPs for publicly traded MLPs. A GP's incentive distribution can be as little as 1 to 5 percent for the first distribution tier, and as high as 50 percent of cash flows for the highest tier known as the high split. Obviously, GPs don't get the high splits until they achieve some significant distribution growth over time for the LPs. When you buy an MLP you become an LP unit-holder. This doesn’t entitle you to control or voting rights over the operation of the MLPs assets; you can, of course, sell your MLP units at any time just as with a common stock. However, you do have ownership rights over the majority of those assets and receive regular distributions of cash from the partnership. This brings us to taxation. The advantage of an MLP is that unlike a corporation, these securities don't pay corporate-level tax. Instead, the majority of their cash flows are simply passed on to the LP unit-holders. Individual unit-holders are, in turn, responsible for paying tax on their share of the MLP's income. In most cases, 85 to 90 percent of all operating profits earned by the MLP are passed along to LPs (before the GP's take). This is behind the high yields offered by the sector. Better yet, unit-holders aren’t responsible for paying tax in the same way they would be for dividends on a common stock. That's because the IRS treats some of the distributions as a return of capital, not normal income. Typically, roughly 10 to 25 percent of the annual distributions from an MLP come in the form of ordinary income and are taxed at the full income tax rate. Because the MLP is able to pass on part of the depreciation tax shield to unit-holders, the rest of the annual distributions are considered a return of capital. Return-of-capital distributions lower your cost basis in the MLP. Ultimately, this will raise the capital gains you have to claim when you sell the MLP which would be taxed at the capital gains tax rate (currently 15 percent for long-term gains). However, until that time, this income is untaxed. The ability to defer income taxes is an obvious and attractive advantage for many yield-seeking investors.
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