Why You Should Sell your Bonds for the Safety of MLPs

Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Investors continue to dive head first into bond funds on the assumption that consistent positive returns are inevitable.  According to the Investment Company Institute, more than $290 billion NET dollars have made their way into long-term bond funds this year.  In contrast, more than $110 billion NET dollars have been withdrawn from total equity funds.  This situation has lasted longer than many anticipated and to some degree has held back the performance of equities.  However, this is the market psychology on which secular bull and bear markets are defined.  The turn never comes as soon as expected, but it always comes.  This day of reckoning is approaching for investors that have forever said goodbye to equity investing. 

The potential in equity investing is quite simple- much higher returns for higher volatility.  Not necessarily higher risk.  Risk is the permanent loss of capital that can arise from valuation, bad management decisions, or technological obsolesce - NOT stock price volatility.  Investors can position themselves in stocks that have attractive valuation, solid management teams, and reside in stable and favorable long-term industries.  Doing so would create a portfolio with manageable risks and significantly higher return potential.   A current undervalued sector that equity investors can add to without incurring a lot of additional risk is the MLP sector. 

The Relative Value Case

MLPs, short for Master Limited Partnerships, currently offer a compelling opportunity.  The current benchmark of the MLP sector, the Alerian MLP ETF, has an indicated dividend yield of 6.32%.  This is often compared to investment grade corporate bonds to gauge relative value.  Historically, MLPs average a yield that is 65 basis points higher than the Moody’s Corporate Baa Index.  Today the yield is 178 basis points wider with 30-year investment grade bonds yielding just 4.54%.   The following chart shows the yield for investment grade bonds at a 50-year low using quarterly quotes. 

Moody’s Baa Investment Grade Index Yield

 

Would you rather lock in 4.5% for 30 years or invest in a sector that currently pays 1.7% more and serves as the toll roads to what the International Energy Agency says will be the largest oil producing country in the world by 2020?  And there is currently a bit of a shale gas boom going on as well.  Without a doubt, the United States in poised to need vast amounts of infrastructure to support these new discoveries.   MLPs are poised to serve as that backbone to the growing domestic energy boom that will last decades.  Plains All American Pipeline (NYSE: PAA) referenced this strong demand in their recent quarterly results.

“The environment for crude oil production growth in North America remains very favorable and we continue to experience strong demand for our assets and services…We are also expanding our asset base to meet the growing needs of our customers. Thus far in 2012, we have invested approximately $2.5 billion in organic growth projects and acquisitions and expect to incrementally invest over $1 billion in organic growth projects through the end of 2013. These investments provide meaningful visibility for increased baseline cash flow and distributions to unitholders."

Favor Spin-offs

Back in June I highlighted Marathon Petroleum Corp (NYSE: MPC) as a name that was poised for imminent outperformance.   The thesis has panned out with the stock returning 55% against a 7% gain for the S&P 500.  Part of the thesis included the likely spin-out of the company’s pipeline assets.  This materialized on Oct. 26 with the IPO of MPLX LP (NYSE: MPLX) at $22 per share.  The stock exploded 23% on day one and has been relatively flat ever since.  The stock remains a compelling opportunity as highlighted in the initial article.  The parent company can drop down assets at fair market multiples in a range of 8-10x EV/EBITDA that is favorable to both parties.  This, combined with the secular growth environment should fuel continued capex opportunities and ultimately steady growth in distributable cash flow. 

The track record for such pipeline spin-offs is quite remarkable, albeit in a small sample size.   The chart below highlights five spin-offs from independent refiners that occurred since 2000.  It shows the percentage outperformance relative to the S&P 500. The five listed below averaged a 62% outperformance in just the one year following their IPO.  These results occurred in both bull and bear markets.  MPLX is the latest company and if it follows this pattern, there is plenty of upside beyond the 23% pop that has already occurred. 

 

Foolish Bottom Line

MLPs have been relatively weak all year long with a total return that has lagged the S&P 500 by more than 10%.  The looming fiscal cliff and related tax law issues have only served as a headwind.  This creates an opportunity for patient, long-term investors.  While there are tax complexities with this asset class, the overwhelming relative valuation to bonds more than overcomes this.  Swapping out of bonds and into MLPs should offer significant upside to one’s portfolio without adding a burdensome amount of risk.  My preferred name remains MPLX, but bellwethers such as Kinder Morgan Energy Partners and Enterprise Products Partners remain attractive as well.  Investing in the Alerian MLP ETF adds instant diversification and should ensure steady cash flows that exceed bonds while also realizing significant capital gains over longer holding periods.    


market8 owns shares in MPLX. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Enterprise Products Partners L.P.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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