How to Beat the S&P with Master Limited Partnerships

posted on 06-07-2019

Before I moved to Texas -- now some 17 years ago -- I lived in a very old house in Poughkeepsie, NY. There wasn't a weekend when I wasn't repairing, maintaining or restoring something.

I would watch episodes of "This Old House" in attempt to learn better ways to address my house's needs. But invariably, I would end up being jealous of Norm Abram, the show's master carpenter. Norm had more tools than a hardware store. I think they even invented tools for Norm to use.
Norm was right. If you have the right tool, even the hardest job becomes easy. And to some extent, income investing can be a hard job -- especially when investing in a low-yield environment.

But fear not, income investors, there is a tool designed specifically for you!

In the past 10 years, the S&P 500 has returned an average 0.2% a year. However, what if I told you there is a class of income investments that has returned an average of 10% annually during the same time frame?    

Master limited partnerships (MLPs) are publicly traded partnerships -- and they are designed specifically for income investors.

MLPs allow for "pass-through" income, meaning they are not subject to corporate income taxes. This design allows more income to flow directly to their investors, or "unit holders." So it should come as no surprise that MLPs, on average, yield 7.1%, while the S&P 500 is dishing out an average yield of just a fraction of that amount.

Most MLPs operate the pipelines and infrastructure used to transport and store petroleum and natural gas around the United States. The oil and gas business can be volatile, especially for exploration and production companies that collect revenues based on fickle commodity prices. But most MLPs charge fees based on the volumes they transport and store. Volumes are far more stable than commodity prices. And that translates into stable income for investors.

For example, take a look at the MLP Kinder Morgan Energy Partners (NYSE: KMP). During the past four years, the monthly spot price of oil has been on a roller coaster -- rising to more than $130 per barrel and falling to near $40 per barrel. Through it all, KMP kept pumping out its quarterly distribution.

In fact, KMP boosted its operating income by 32.1% in 2009.

Tax Implications

MLPs are a unique investment class. They can generate a type of income called unrelated business taxable income (UBTI). And that makes holding individual MLPs a little trickier tax-wise. Because of the tax implications of UBTI, individual MLPs aren't suitable for IRAs or other tax-deferred accounts. If your retirement account earns more than $1,000 of this type of income, it will be subject to taxation -- which opens up a whole can of worms for you and your IRA company. As a result, you probably want to hold MLPs in a regular, taxable brokerage account.

Historically, most MLP distributions are comprised of about 20% net income and 80% return of capital (which is really just an allowance for depletion or depreciation). The income portion is generally taxed at your ordinary income tax rate.

You don't pay taxes on the return-of-capital portion until you sell the security, making MLPs ideal for long-term investors. Return-of-capital distributions lead to a reduction in your cost basis. If you pay $50 a share for an MLP, for example, and receive a $5 return-of-capital distribution this year, then the cost basis of your shares declines to $45. If you sell the shares next year for $55 a share, you will have to pay taxes on your $10 gain. Investors in individual MLPs will get mailed a K-1 tax form each year that specifies the tax treatment of the prior year's payout.

If you have your heart set on investing in MLPs but only have investable money in a retirement or tax-deferred account, there are a number of closed-end funds that primarily hold MLPs. These funds do not pay UBTI, so investors do not have to worry about having an unintended tax consequence in their retirement accounts.

Whether you own individual MLPs or an MLP fund that does the heavy lifting for you, you can generally count on an above-average yield and a dependable distribution.