Income Growth Advisors, LLC MLP strategy’s market value declined in August by 2.05% after 5 straight months of gains. We continue to produce strong performance and outperformance with returns up 26.73% year to date on a size weighted basis and 61.28% year to date on an equal weighted basis. We expect a moderation in our recent return trajectory, but believe that our MLP strategy could produce total returns on the order of 50% over the next two years.
Oil and MLPs bottomed in February following historic 75.24% and 56.58% declines in the commodity and the MLP TR Index, respectively. While MLPs and midstream pipeline MLPs, in particular, were considered to be relatively immune to the price of oil, the size and duration of the decline in oil, which peaked at $107/bl in June 2014 and bottomed this January at $26/bl, overwhelmed the energy industry fundamentals and led to a collapse in the “non-correlation” between MLPs and oil. Because this non-correlation was so widely believed, as a credible defensive characteristic, Wall Street over invested in MLPs, which led to a classic boom-bust cycle where irrational exuberance and leverage swung to panic and broad based liquidation.
This severe decline led to the current general misconception that fee based and toll road midstream energy MLPs are highly correlated to oil, when, in fact, they are not. Within normal ranges of commodity volatility, there is little correlation between MLPs and oil; however, in extreme commodity moves, they are closely correlated. MLPs as a financial asset can be subject to boom bust cycles as Wall Street over promotes and over leverages the sector and then experiences a severe contraction wiping out the excesses leaving many investors with losses.
Now that the market has begun to rebalance and the global oversupply of crude oil is forecast to decline over the next 12 months, we anticipate stability returning to the business operations of MLPs. As the industry recovers, the memory of the sharp decline of MLPs will fade and MLPs will trade back to levels in line with other alternative yield vehicles. Specifically, we expect that the yield spreads of MLPs compared to US Treasury bonds, corporate bonds and Real Estate Investment Trusts (REITs) will contract as the energy industry returns to stability over the next two years. During this period, we anticipate that MLP sector yields will decline from their present 7.24% yield levels by 2.5%. Currently, MLPs yield 5.63% (563BPs) over 10-year Treasuries versus their historic low spread of 2.68%. MLP yield spreads versus Moody’s Baa bonds are 3.04% (304BPs) and those spreads have been negative. And lastly, MLP yields versus the REIT Index are 4% (400BPs) compared with a low spread of 2.2% (220BPs). So a reasonable normalization should lead to a 2.5% drop in MLP yields.
We believe that the long term appeal of the MLPs’ tax advantaged income, distribution growth prospects, and US energy industry’s growth will drive continued superior returns relative to other income alternatives in this historically low interest rate environment. Assuming a ten-year duration for MLPs, a 2.5% drop in yield would lead to a 25% capital gain. Assuming an 8% yield, a two-year distribution return of 16% can be added. Lastly, our out-performance relative to the Alerian index has ranged between 5-10% per year in recent years. Assuming two years of our historic average outperformance of 3.98% is added, we see a potential total return of 49% (=25% + 16% + 8%) over the next two years.
For optimal performance, we recommend investing in MLPs through separately managed accounts and avoiding MLP mutual fund structures. These investment vehicles are subject to taxation of approximately 30% defeating the tax free corporate structure of the Master Limited Partnership. This negative tax consequence, for the convenience of avoiding K-1s, is shown graphically on page 26 in our attached PowerPoint Presentation. For investments in excess of $100,000, it makes sense to own MLPs outright with a top MLP manager. In that regard, we work with US Trust/Bank America/Merrill Lynch and Interactive Brokers.
Sincerely,
Tyson Halsey, CFA
Managing Member
See performance disclaimer at end of attached presentation.