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This is the fourth in a series of five articles looking at the most popular bond alternatives and the safest ways to use them to improve your income prospects when rates are low. Adapted from “Reaching for Yield” in the January/February issue of Money magazine.
Like the real estate investment trusts we mentioned previously, master limited partnerships pass on to investors most of the income they generate from their core business, typically storing or transporting oil, natural gas, and other energy resources. And like REITs, MLPs spent much of 2014 looking frothy. In the 10 years through September, these shares nearly doubled the gains of the S&P 500. As a result, by fall MLPs were yielding only 2.7 points more than 10-year Treasuries, vs. their typical premium of 3.2 percentage points.
Since then, the partnerships have suffered a sharp reversal. As fears of a global slowdown grew, oil prices slid by more than half to $46 a barrel, and skittish investors started dumping MLP shares. That has pushed the average MLP yield up to 6.2%, which means they’re now paying more, relative to Treasuries, than they have historically.
Many analysts believe the panic has been overdone. While a minority of MLPs are involved in drilling and oil production, most are pipeline companies that simply collect transmission fees, with much of their revenues set by long-term contracts.
Still, these complex investments aren’t for everyone. As a result of the partnership structure, payouts from MLPs are considered a return of capital, on which taxes are deferred until you sell. That tax benefit can create a paperwork nightmare, since you may have to file separate tax returns in states the company operates in so there is a government record of the income you’ve received, notes Tom Roseen, head of research services at Lipper. You can invest via a fund that will eliminate the need to file, but that is likely to reduce your returns.
Your best strategy: Since these are still rocky times in the energy sector, your best bet is to go with a fund that gives you exposure to a diversified collection of MLPs. Stick with a fund that focuses on pipeline companies and that won’t tie you up in tax knots. That means investing via an ETF that’s set up as a corporation, not as a partnership.
One fund that meets all the criteria, says Kinney: the Alerian MLP ETF , which tracks an index of pipeline MLPs. It paid out 6.25% last year. But thanks to the pullback in share prices and a 4% hike in its distributions in 2014, buyers are likely to collect a yield of almost 7% in 2015. Because it is a corporation, not a partnership, Alerian can’t defer taxes on its payouts; that gets rid of the hassle of filing multiple state returns every year. But convenience comes at a price: The tax bite dampens Alerian’s total return relative to other MLPs. If you’re focused on income, though, that 6% to 7% yield may be ample compensation.