I sat down with a high net worth investor in New York this week. He was nervous about allocating more of his net worth to MLPs, because of his perception that MLPs are very expensive. I’ve talked with other investors that have similar feelings about the broader markets and are wary of putting fresh money to work in stocks generally given the recent strength in the market. The market’s range the last few years has conditioned investors to be cautious that big downside volatility is always lurking around the corner.
I believe there are pockets of good value within the MLP space, and there are also MLPs that are expensive. In late 2011 and through 2012 there has been growing dichotomy in the sector between MLPs investors are willing to pay up for and those for which investors are not willing to bet on. MLPs haven’t been locked into a range like the broader market since the beginning of 2009; it’s been more of an upward sloping ramp, with a few potholes along the way.
A simple chart of average distribution yields by MLP asset type helps illustrate the variance in current MLP valuations. Large cap MLPs and MLPs with crude oil exposure are trading at lower yields (higher valuations) than other MLPs. Valuation differences amongst MLPs have always existed, but those differences have grown more pronounced in recent years.
MLP investors I speak with have been disappointed not to see an August swoon for MLP like we’ve seen the last 3 years in August, so they could buy some of the expensive MLPs they like. I’ve experienced that as well, waiting for an entry point on some target MLP holdings, but instead watching them rise higher each day–Tesoro Logistics (TLLP) is one example. Fresh institutional capital and new MLP products seem to be filling the potential potholes before we fall into them so far this year. There also hasn’t been a big tax scare to drop valuations in the MLP space and even drastically lower coverage ratios for commodity sensitive MLPs this quarter hasn’t negatively impacted MLPs too much.
That conversation and others prompted this column, and others to follow, on the subject of MLP valuation. You (loyal readers) and I will get to the bottom of where the sector stands currently and hopefully determine whether the sector is expensive or not.
The easiest metric to point to for MLP valuation is yield. A lower yield implies a higher valuation, so a very low yield is a sign of a very high valuation. As of last today’s close (8/16), the MLP Index carried a 6.24% distribution yield. As shown in the chart below, that 6.24% current yield is below historical average MLP yields, but almost 100 basis points above the all-time low yield of 5.37% (in July 2007), and well above yields from earlier this year and from early 2011.
Distribution yield is flawed, primarily because MLP management teams control how much cash is distributed, and that decision impacts yield. During cautious times MLPs may carry higher coverage ratios (i.e. they may hold back more cash), which if all else is equal would lead to lower yields for MLPs than if they all paid out 100% of distributable cash. Having said that, current distribution yield is one important metric that many MLP investors follow.
As of right now, MLPs look expensive on a yield basis relative to where you could have purchased them in the past. But, as everyone knows, a 6.2% yield relative to what you get in a savings account or by investing in US Treasuries (1.84%), is very attractive, so next we’ll review MLP yield spreads relative to treasuries and high yield bonds. In this case, once again, a higher number (wider spread) implies cheaper.
MLPs still look cheap relative to US treasury yields, although with the 10-year rate increasing almost 20 basis points this week from 1.65% to 1.84%, and with MLPs continuing upward, the spread has narrowed 25 basis points in the last 4 trading days, making MLPs appear slightly less cheap on this one metric.
Treasury yields don’t have a comparable risk profile to MLP yields. The table below compares the MLP index yield with the average yield of Moody’s BAA-rated (just above investment grade) 30 year corporate bonds, so similar corporate credit profiles, although bonds carry less risk within the capital structure of course.
Again, MLPs look cheap compared with historical spreads, but not by much. When the bond market is priced for no growth, like today, it’s important to note that MLPs can grow distributions over time (and they have). Total return for MLPs are almost always going to be higher than bonds in the absence of interest rate decreases, which in the past several years has boosted total returns of bond portfolios massively.
Maybe a better MLP comparable is another yield-based equity grounded in hard assets: equity REITs. The chart below offers a comparison of the yield of the MLP Index (on a monthly basis), compared with the NAREIT Equity REIT Index. For those that don’t know, equity REITs actually invest in properties, as opposed to mortgages, which makes equity REITs a better comparison to MLPs than an index of all REITs.
MLPs closed July with a yield that was 283 basis points higher than the equity REIT index, which is a tighter spread than the average the last 3 years, but is wider than longer time horizon comparisons. I would say MLPs look cheap relative to REITs based on the data above, but a case could be made that that MLPs are structurally cheap relative to REITs.
In other words, MLP assets are generally more attractive and stable than REIT assets. Some investors believe MLPs should trade at least on par with REITs in terms of yield. If that were to happen someday, everyone who owned MLPs at today’s prices would be very happy. MLPs have not significantly narrowed the yield gap over the years, probably due to the smaller market cap of the MLP sector and the challenges large institutions face when considering investment in MLPs vs. investment in REITs.
So, to review, MLPs look expensive relative to historical MLP yields, but look cheap relative to yields of 10 year U.S. treasuries, corporate bonds and REITs. Stay tuned for next week’s column where we review how MLP valuations look in terms of other valuation metrics, like EBITDA multiples, distributable cash flow multiples and dividend discount models.
Disclosure: The information in this article is not meant to be financial advice, I am not your financial advisor and I am posting my comments for informational purposes only.