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The Search for Yield Compression

By Elliott H. Gue on Jun. 17, 2014

The master limited partnership’s (MLP) lineage dates back to 1981, when exploration and production outfit Apache Corp (NYSE: APC) consolidated 33 of its oil and gas operations into this structure.

In the mid-1980s, the universe of publicly traded partnerships differed dramatically from the options available to today’s investors. With no limitations on what assets and operating businesses could adopt the MLP structure, the universe of publicly traded partnerships expanded rapidly and included restaurants, nursing homes, shopping centers, forest products and amusement parks. Even professional sports franchises got in on the action, with Boston Celtics LP raising $48 million in an initial public offering shortly after the team won the 1985-86 NBA championship.

Alarmed by the upsurge in companies converting to MLPs or spinning off assets into this tax-advantaged structure, Congress passed the Tax Reform Act of 1986 and the Revenue Act of 1987, which sought to prevent a diminution of the corporate tax base. This legislation requires publicly traded partnerships to generate at least 90 percent of their gross income from “qualifying” sources, the majority of which relate to the production, processing and transportation of oil, gas and other natural resources.

Despite the dramatic changes that have occurred in the universe of publicly trade partnerships since the 1980s, the basic appeal of this security class to investors has remained the same: above-average yields and significant tax advantages. 

In a March 1987 article published in the Wall Street Journal, Barbara Donnelly wrote: “Investment bankers specializing in [master limited] partnerships say that in order to be competitive an issue must offer a current return of 9 percent to 10 percent.”

Twenty-five years later, it’s still all about the yield for many investors, especially as retiring baby boomers shift their focus from accruing assets to transforming accumulated savings into a reliable income stream.

This “strategy” of focusing on high-yielding names worked wonders in the aftermath of Lehman Brothers declaring bankruptcy; with fear running rampant, investors could lock in double-digit yields on Enterprise Products Partners LP (NYSE: EPD) and other high-quality names.

Publicly traded partnerships with exposure to commodity prices–producers such as Vanguard Natural Resources LLC (NSDQ: VNR) and gathering-and-processing outfits such as MarkWest Energy Partners LP (NYSE: MWE)–suffered the biggest hit during the 2008-09 panic and offered truly gargantuan yields.

In the subsequent recovery rally, the Alerian MLP Index–a capitalization-weighted basket of 59 prominent partnerships–delivered a record 75 percent return in 2009, while MarkWest Energy Partners and other hard-hit names generated total returns in excess of 250 percent.

Much of this upside came from price appreciation, or yield compression. And the same goes for the top-performing MLPs in subsequent years.

From 2011 to 2013, price appreciation accounted for an average of 87 percent of the total return posted by the top-performing MLPs from each year. Thus far in 2014, climbing unit prices have contributed about 93 percent of the total return posted by the top 10 publicly traded partnerships.

A surging unit price also benefits the MLP, which enjoys a lower cost of equity capital relative to higher-yielding peers.

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