Unwarranted Sell-Off In Master Limited Partnerships, Buy the DIP!

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This Just In! Fiscal Cliff Sends High Yielding Equities Lower!

Fear of a "fiscal cliff" was said to be a big factor in November's significant under-performance of many high yielding stocks and Master Limited Partnerships, "MLPs." Obama's reelection was also discussed in connection to the meaningful decline of energy-related stocks and MLPs. For example, in November Utility sector ETF Utilities Select Sector, (NYSEMKT: XLU) was down as much as 8% compared to the S&P500 Index and ended the month down 5%. That's a lot for a low volatility sector like Utilities in single month. In many cases MLPs fared even worse, For example, two of my favorites, Alliance Resource Partners(NASDAQ: ARLP) and Natural Resource Partners, (NYSE: NRP) trailed the S&P500 by 13% and 15%, respectively!

The fiscal cliff debate is triggering the sale of stocks for two reasons. First, stocks with high dividend yields are getting hit because qualified dividends might revert back to being taxed as ordinary income. Second, some  investors are selling stocks in which they have capital gains to avoid possibly higher capital gains tax rates next year. Foolish investors are no doubt aware of the fiscal cliff debate, I'm not introducing anything new here. The thesis of this article is that selling MLPs with greater fervor than that of say utility stocks is completely unwarranted. 

MLP's Are Fundamentally Different Than Common Stocks

Investors are painting all high yielding equity investments with the same fiscal cliff brush. Doing so misses a crucial difference between common stocks and MLPs. Qualified common stock dividends are currently taxed at a preferential 15% rate. Units of MLPs are taxed differently. A meaningful portion of a MLP's distribution (distribution being a fancy word for dividend) is deemed a, "return of capital." This key difference, (and others) allow a large part of a MLP's distribution to be tax deferred. Investors keep most of the distribution but pay taxes on the distributions when the units are sold. [Please consult with your financial advisor or a tax accountant for further information].

Upon the sale of a MLP, the accumulated distributions are effectively taxed as ordinary income, i.e. a tax rate of 35%-39%. Therefore, investors benefit from the deferral of taxes, but pay a higher tax rate upon the sale of units. Ok, now hold on to your hats readers, here comes the punch line. The contemplated changes in the tax code, the big bad wolf, the fiscal cliff....WOULD NOT negatively impact MLP distributions because MLP distributions are already taxed as ordinary income! To reiterate, tax on qualified common stock dividends could rise from 15% to 35%-39%, but MLP distributions are already taxed at the higher rate, albeit on a tax deferred basis.

To be fair, MLPs would be negatively impacted with regard to capital gains taxes. BUT, the capital gains tax rate is possibly going up by only a few percentage points. The increase in capital gains tax rates is not the BIG fear. The BIG fear is that qualified common stock dividend tax rates could more than double. I can understand the thinking behind the sell-off in high dividend common stocks in sectors like Utilities, Telecom and Health Care. But an even greater sell-off in MLP's makes little sense.

MLPs Could Be Poised for a Meaningful Snap Back

And, the story does not end here. There are a number of reasons to largely ignore the fiscal cliff debate when it comes to income generating investments. First, a compromise or solution is possible, if not likely, in coming months. Yes, that's months. Retroactive policies can always be enacted next year (after plunging off the fiscal cliff on January 1). Second, even if tax rates on capital gains, ordinary income and qualified common stock dividends go up, the highest yielding investments today will still be the highest yielding investments going forward. Retirees and others interested in earning a decent yield will have the exact same choices, (Common Stocks, MLPs, Muni bonds, Corporate bonds, REITs, etc).     

Taking the discussion a step further, if tax rates on qualified common stock dividends do go up next year, then distribution yields on MLPs will be look a lot more attractive on a RELATIVE basis. All else equal, this should increase the demand for MLPs relative to high yielding common stocks. Not only should MLPs not be selling off as much as high yielding common stocks, they might even experience a substantial snap back.  

Foolish investors should get their Holiday wish lists in order. MLP's could be the gift that keeps on giving next year. While I like Alliance and NRP, there are many other energy-related MLP's offering attractive yields. Once again I recommend that prospective investors in MLPs consult with investment professionals regarding the taxation of MLPs.    

MockingJay2011 owns shares of Alliance Resource Partners, L.P. and Natural Resource Partners LP. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Alliance Resource 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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