Warning: This Popular High-Yield Investment is a Terrible Choice

It may be alluring, but if long-term, reliable incomThe siren song of rising distributions and rising unit prices can prove irresistible to income investors.

The song is so inviting.

The rising stream of quarterly distributions lifts the unit price ever higher. A perpetual-motion machine appears to have emerged. The prospect of perpetual distribution increases inspires a gusher of fawning analysis. The unit price rises higher still.

Such is the privileged life of the distribution-growth master limited partnership (MLP).

“Apparent” is the operative word. Perpetual-motion machines are only apparent.

What appears perpetual is always a fleeting illusion.

The quarterly distribution increases cease, as does the rising unit price.

After the quarterly distribution ceases to rise, it might levitate for a few quarters.

During this stage, the general partners will swear up and down, come hell or high water, that the distribution is sacrosanct.

True enough, until the distribution is no sacrosanct. The levitating ends, the distribution is cut for the MLP investment.

As the distribution goes, so goes the unit price. I offer Energy Transfer Partners (NYSE: ETP), StoneMor Partners (NYSE: STON), and Calumet Specialty Products Partners (NASDAQ: CLMT) as personal indictments.

The MLP structure is the allure. Pay no federal income taxes if you generate at least 90% of your income from qualifying sources: the production, processing, storage, and transport of natural resources (usually oil and natural gas).

Untaxed earnings ramp up the income possibilities. Incentives further amplify the possibilities.

The partnership agreement typically states that the MLP distribution must comprise all available cash flow, less a reserve determined by the general partner (the MLP’s management team). The general partners are motivated to keep reserves low. The higher the quarterly distributions paid to limited partners (the unitholders), the higher the management fee paid to the general partner.

What can go wrong?

In short, everything, and everything goes wrong more than income investors anticipate.

The days are 75 degrees and San Diego comfortable as long as the price of the commodity behind the MLP remains elevated. When it is 75 degrees, MLPs swamp the market with new debt and equity to grow. MLPs have no other options to finance growth when nothing in the till after distributions are paid.

Of course, 75-degree days never last, even in San Diego.

Commodity prices are, and always will be, volatile. Before you know it, you’re no longer in Southern California. You’re traversing Cape Horn at the southern tip of South America when the williwaw winds kick in.

Oil that trades at $100/barrel one year will trade at $40/barrel the next. Interest and distribution payments predicated on $100/barrel oil are unsustainable at $40/barrel. As much as general partners profess their desire to maintain a sustainable distribution, the business formation won’t allow it. Reality mandates a distribution cut.

When your leader bows out, perhaps you should bow out, too.

Pipeline giant Kinder Morgan (NYSE: KMI), the originator and exemplar of the MLP model, abandoned the model and its formerly high-yield distribution (cut to a low-yield distribution) a couple years ago. It’s now organized as a regular C-corporation. Kinder Morgan pays corporate taxes now, but it also keeps something in the till for the inevitable rainy day.

The MLP model is even less attractive today than when Kinder Morgan abandoned it.

Corporate income taxes were lowered to a flat 21% from a 35% top rate this year. The lower corporate income tax rate renders the pass-through model less attractive compared to the lower corporate income-tax rate.

The MLP structure was further compromised by a US. Federal Energy Regulatory Commission (FERC) ruling last week. FERC declared that interstate pipeline MLPs will no longer be allowed to recover an income tax allowance in cost-of-service rates. These MLPs can no longer claim a credit for income taxes they do not pay.

I’ll concede that MLPs are an enticing income speculation at their depressed prices. But an MLP investment can never be an enticing permanent addition to an income investment portfolio. If long-term, reliable income and principal preservation are the goal, MLPs fail to supply the means to reach the goal.

— Steve Mauzy

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Source: Wyatt Investment Research