Interest rates are rising across the yield curve all of a sudden. The interest rate on the 10-Year U.S. Treasury (UST) has increased 31 basis points from 1.98% to 2.29% so far in March. But rates are rising from historic lows, and when looked at in the context of a 5-year chart like below, the move barely registers.
More than half of that increase came March 14th when the 10-year rate rose by 16 basis points. An increase in the 10-year UST interest rate of more than 15 basis points on a single day has only happened on six days in the last two years. Surprisingly, MLPs don’t always go down on those days. MLPs traded up on three of those six days and averaged 0.0% returns over the six-day sample.
Perhaps not coincidentally, MLPs have performed poorly thus far in March, and there is a rush to attribute underperformance to the rise in interest rates. All yield based securities are subject to the risk interest rates will rise for a sustained time period. The line of reasoning goes like this: Why would I buy an MLP with a 5% yield if the 10-Year UST bonds are yielding close to 5%? And that line of reasoning would make sense if the yield on USTs were actually 5%, but it’s not even close, and until interest rates break above 4%, rate increases are not likely to have much effect on MLP performance.
Recent Interest Rate Spikes Have Coincided with MLP Gains
Recent precedents prove my point. Interest rates have gone down more than up over the last decade, so it’s hard to find comparable time periods, and interest rates have never been as low as they have been for the last several months, so there are not many precedents for what MLPs will do if the 10-Year UST rate rises from 2% to historical averages like 3.5% or 4.0%.
The table below highlights the two times since at least 1995 that the 10-year rate rises from less than 2.5% to more than 3.5%. MLPs did fine in both cases.
I believe the MLP swoon so far in March can be attributed more to investors rotating out of the sector after three straight strong months for MLPs and a 20%+ move since early October. Also, on the whole, MLP earnings were generally weaker relative to expectations than they have been in the past few years. Wells Fargo research confirms my anecdotal evidence in their monthly MLP report published on March 8th. Wells Fargo says a lower percentage of MLPs that the firm covers missed earnings expectations this quarter (40%) than in any quarter in recent memory and compared with a historical average of 30%.
Yield Spread Snapshot
From 1996 through March 21, 2012, MLPs have averaged a 313 spread to the 10-year UST rate, similar to the average spread since 2000 and 2004. However, since 2008, the spread has remained consistently wide. For the vast majority of the days since 2008, the 10-year rate has closed below 4%. As shown below, the average spread since 1996 when the 10 year is above 4% is almost 200 basis points smaller than when the rate is sub-4%. At a current spread of 371 basis points, MLPs would appear overvalued on this metric when compared with the average spread since 2008 and when the 10 year is above 4%.
That simple thinking fails to account for the slower than average MLP distribution growth and depressed valuations we have seen since 2008. MLPs are currently positioned to grow distributions more rapidly than at any time since the beginning of 2008. Higher growth equals lower yield, all other things being equal. When taking into account growth, MLPs may be fairly or undervalued currently.
Yield spreads are not the most important thing in the world for valuation. Distribution coverage and growth can distort the numbers. In times when MLPs are holding back more cash (and therefore have higher distribution coverage), MLP Index yield and the UST spread will be tighter than the spread would be if MLPs distributed all of their cash. In that sense, MLP yield for the Alerian MLP Index in boom times is arbitrary, determined by how much coverage the MLPs in the index choose to carry. When times are not as great for MLPs, distribution yield more closely approximates distributable cash flow yield (or the yield that MLPs would have if they had 1.0x coverage (i.e. paid out all of their free cash).
Interest rates are not a driving force behind MLP price changes in the short or medium terms. Interest rates should not be a primary reason for you to purchase or sell MLPs, at least not until rates rise another 150 basis points from here. Focus instead on finding MLPs that are likely to benefit from macro energy trends like growth of shale production and high NGL prices.
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