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7 low-risk cash cows yielding 6%
Little-known vehicles called master limited partnerships offer investors a piece of the action in energy and pipelines, steady cash flow and growth potential.
By Michael Brush
When even the Warren Buffett of the bond world -- Pimco Chief Investment Officer Bill Gross -- dumps shares in the very bond portfolios he helps manage, you know something is amiss with bonds.
Whats so scary about bonds? Resurgent economic growth has the Federal Reserve making noises about raising interest rates -- and that makes bonds less attractive.
Yet many people still need to invest to produce income for living expenses, or theyre looking for alternatives to the measly returns of money market funds or short-term bonds, for that matter.
Where can they turn to find a substitute?
One great option is a little-known but high-yielding corner of the investment world known as master limited partnerships (MLPs). In a nutshell, these are relatively safe investment vehicles -- usually in the energy sector -- that throw off 6% to 8% a year in the form of quarterly cash payments. Often, those payments grow as much as 7% a year. And they do all this in a way the lets you defer taxes, which is always a nice thing.
Seven attractive MLPs, according to buy-side analysts and A.G. Edwards Ronald Londe, include: energy pipeline companies Teppco (TPP, news, msgs), Crosstex Energy (XTEX, news, msgs), Plains All American Pipeline (PAA, news, msgs) and Valero (VLI, news, msgs); gas processor MarkWest Energy (MWE, news, msgs); propane distributor Inergy (NRGY, news, msgs); and coal distributor Alliance Resource (ARLP, news, msgs). Londe says you should own at least five of these to get good diversification.
If youve never heard of MLPs, join the club. This little cash cow that could gets lost in the shuffle for three reasons:
- They are a little tricky to understand at first, so people tend to skip over them.
- Mutual funds cant own them, for the most part. So that parade of money managers on TV never touts them. (The Bush administrations energy bill, however, would let mutual funds invest in MLPs.)
- The term limited partnerships dredges up bad memories of a series of devastating investment scams in the 1980s where investors lost billions investing in partnerships that never made a dime.
MLPs suffer a bit from guilt by association. Fact is, they are an entirely different animal, and they dont carry the risks that those 1980s partnerships did. There are other risks, of course, but well explain those in a moment.
To get a handle on how MLPs work, we turned to the best experts in the world. We went to Vinson & Elkins, the big Houston law firm that has had a hand in setting up 39 of the 40 MLPs created in the past 15 years. Thats a good start. We also checked in with Energy Income Partners in Westport, Conn., and Kayne Anderson in Los Angeles, two money-management firms that specialize in investing in MLPs, and with A.G. Edwards Londe. Heres the lowdown on MLPs.
Read more on income investing at MSN Money
Nuts and bolts of an MLP
First, by law, they mainly operate in the energy and natural resources fields.
Like stocks, MLPs are traded publicly. Most are listed on the New York Stock Exchange. But when you buy one through your broker, you are buying a unit (not a stock) that in essence makes you a limited partner in the MLP. Its that easy. In exchange, you get all the benefits of belonging to a partnership -- which include the following:
A good combination of income and growth.Under the partnership agreements that set them up, MLPs have to give investors most of their cash flow in quarterly distributions. Those distributions are typically big enough to produce an annual yield of around 6% to 7% on your initial investment.
And its easy to find MLPs that are increasing their distributions enough so that if you hold one of them for a few years, youll be enjoying an annual yield of 15% or more. There arent many investments out there today that give you that much cash on cash return, says Barry Miller, an MLP and tax expert at Vinson & Elkins.
You get piece of the action in a relatively safe business. Many of the better MLPs are growing by purchasing oil and gas pipelines. Theyre on the market because the big oil and gas companies want to raise capital to develop promising fields in places like Nigeria and Siberia. So they are selling off some of their slower-growth operations and pipelines in the United States.
The pipeline business is relatively safe for two reasons. First, energy-price fluctuations are irrelevant, since these pipeline MLPs are paid for moving oil and gas around. Second, most of the fees they charge are set by regulators, which makes them very predictable, says Jim Murchie, who analyzes MLPs for hedge funds run by Energy Income Partners. Murchie has about 30% of his own net worth invested in MLPs.
You get protection against dumb management moves. Like it or not, many managers do a pretty lousy job of reinvesting cash from their businesses. But with an MLP, you are buying into a structure that forces management to give you the cash. To make an acquisition, the partnerships management must have to ask your permission to issue new equity. The first question is, will it add to earnings? And if the answer is no, the meeting is over in 30 seconds, says Murchie.
You can defer taxes. Well get to the details in a moment. But essentially you can put off paying most of the taxes for as long as you want. That frees up more money for you to use now. And if you delay your taxes long enough, your tax bill falls because you are usually taxed at a lower rate in retirement.
What to look for in an MLP
First, you want to go for those that already pay a big distribution -- and you want to see that its going to keep growing in a healthy manner. One good thing about the seven MLPs on our list is that they all pay out between 6% and 7% annually, and theyre all on track to increase those distributions by 5% to 10% a year over the next three years.
Next, since MLPs often issue debt to raise money to invest and expand, you want to see some financial strength. Look for a debt-to-capital ratio below 55% as a rule of thumb, says J.C. Frey, an MLP expert at Kayne Anderson.
You also want to look for signs of strategic thinking by management. When Plains All American buys a new pipeline, its often because it adds extra value as a good strategic fit with its overall pipeline system, says Bob Sinnott, another MLP expert with Kayne Anderson and a director of Plains All American Pipeline.
To be safe, its better to shy away from MLPs that are exposed to the unpredictable movement of commodity prices. Pipeline companies are fairly safe because their fees are set by regulators. But the fortunes of propane and coal MLPs, or the barge company Martin Midstream (MMLP, news, msgs), depend more than pipeline MLPs do on market prices for their products and services -- prices that can fluctuate rapidly. We do include safer propane and coal MLPs in our seven picks, one each, because you want some diversification across a few sectors.
Some risks and concerns
Those cash distributions, of course, are not guaranteed. So for safety look for a "distribution coverage" ratio of more than 1. Distribution coverage is basically cash flow before accounting adjustments divided by the amount distributed. A ratio of 1 makes it sound like they are just squeaking by. But in reality, all of our seven picks have cash reserves on hand as an extra cushion. And all but one -- Teppco -- have two classes of shares, a dual structure that puts public investors ahead of another share class in case cash is short. So the coverage ratio is really higher than it appears.
Next, MLPs arent suitable for IRA accounts because earnings above $1,000 will be considered unrelated business taxable income by the IRS.
And as income-producing investments, MLPs could get whacked if interest rates and inflation go up too much. But, unlike bonds, they have some powerful, built-in safeguards. For starters, most of the energy-related MLPs on our list are in regulated industries where the tariffs rise in line with inflation. Theyre also increasing their distributions a lot, which helps offset any damage from fears that interest rates are going up.
Finally, many investors in MLPs would face large tax bills on huge amounts of deferred taxes if they sold their units. That is taxed as ordinary income. So, the investors are often reluctant to dump the units just because interest rates are going up.
The nitty-gritty
We saved this for last, because it might make your eyes glaze over. But heres an example of how a typical investment in an MLP works.
Suppose you buy a unit for $20 that yields 10%. That means you get $2 per year, which isnt taxable right away. Now, when tax season rolls around, the MLP sends you a form that tells you what portion of its income gets allocated to you -- based on things like your share of internal tax write-offs like depreciation. You have to pay tax on this allocation. This amount often works out to be around 20% of the total cash distribution. So in this example, you would be paying tax on 40 cents.
As for the tax on the rest of your income, it gets deferred, and heres why: In the eyes of the tax collector, the cost basis of your MLP (which you bought at $20) is reduced by the $2 it gives you. But the basis is increased by the 40 cents partnership income allocation you had to pay tax on. So your new cost basis is $18.40, instead of $20.
Now, let's say you sold yours after one year, and you got $21 for it. (In reality, most people hold them for much longer, but lets keep it simple for the example.) Youll pay ordinary income tax on the $1.60 (your initial unit cost of $20 minus the new cost basis of $18.40). And youll pay capital gains tax on the $1 move from $20 to $21.
Sound complicated? It is. But the bottom line is this: You get to put off paying taxes, which frees up money for other needs now. And if you wait long enough, you may be able pay the taxes in a lower income bracket after retirement. Thats not the same as some of the cushy tax havens enjoyed by the rich and famous. But when it comes to keeping Uncle Sam out of your wallet, every little bit helps.
| 7 income vehicles few of us have heard about | | Company | Business | Feb. 3 price | Annual distribution | Current yield | Est. 3-year distribution growth rate | Distribution coverage* | Debt to capital ratio | | Valero (VLI, news, msgs) | Pipeline | $50.25 | $3.00 | 5.94% | 10.00% | 1.3x | 49% | | TEPPCO (TPP, news, msgs) | Pipeline | $38.61 | $2.60 | 6.72% | 8.00% | 1.1x | 59% | | Crosstex Energy (XTEX, news, msgs) | Pipeline | $44.53 | $3.00 | 6.82% | 8.00% | 1.1x | 25% | | Plains All American Pipeline (PAA, news, msgs) | Pipeline | $31.50 | $2.25 | 7.05% | 6.00% | 1.0x | 40% | | MarkWest Energy (MWE, news, msgs) | Gas processor | $38.37 | $2.68 | 6.96% | 8.00% | 1.3x | 46% | | Inergy (NRGY, news, msgs) | Propane | $23.75 | $1.58 | 6.69% | 8.00% | 1.1x | 41% | | Alliance Resource (ARLP, news, msgs) | Coal | $34.26 | $2.25 | 6.39% | 5.00% | 1.7x | 89% |
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*Cash flow before accounting adjustments divided by cash distribution to shareholders.
Source: A.G. Edwards
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