Master Limited Partnership (MLP)

The day before Thanksgiving in 1996, Rich Kinder left his post at Enron. He was disappointed that Kenneth Lay had passed him over for the job of CEO. Soon after, an old college buddy, Bill Morgan, approached Kinder with a business proposition.

Morgan had just bought some assets that Enron had no use for -- a couple of small pipeline systems and a coal terminal. He needed someone like Kinder to run the business. Kinder agreed and the partnership was christened Kinder Morgan Inc. in February 1997.

Seven months later, Kinder had doubled the company's market capitalization to nearly half a billion dollars by watching costs and shipping more volume through the pipelines. Today, Kinder Morgan Energy Partners is a $10 billion business, operating 25,000 miles of pipeline and 145 terminals throughout the U.S.

Master limited partnerships (MLPs) had already been around for decades, but it took someone like Rich Kinder to transform this asset class from a passive holding company into a dynamic investment vehicle.

In the mid-1990's, Kinder Morgan was one of only about a half-dozen master limited partnerships, which together totaled roughly $2 billion in market capitalization. Today, there are over 50 actively-traded MLPs with a total market cap of nearly $80 billion.

What Makes MLPs so Attractive?
It may have something to do with their enticing yields of up to 11%. Then again, it could be their market-beating annual returns of +17% since 1996. Or maybe it's their exceptional track record for raising dividends an average of 8% to 9% a year for the past ten years that has endeared them to income investors.

Perhaps the best news is that the group is still firing on all cylinders. The benchmark Alerian MLP Index of the 50 largest MLPs has returned a healthy +7% so far this year through the end of July, handily trouncing the S&P's meager +3.6% return over the same stretch.

Safety and Growth -- A Rare Mix
Like real estate investment trusts (REITs), MLPs pay out most of their cash flow to shareholders. As a result, the group carries an average yield of about 6.2% -- more than three times the puny 1.8% yield offered by the average stock in the S&P 500 Index.

But their healthy yields aren't even their main attraction. Rather it's the rare mix of safety and growth that makes MLPs a must-have asset class for your income portfolio.

Although a variety of companies in different industries are organized as master limited partnerships, energy and pipeline MLPs are far and away the most prevalent type. As a result, investors often flock to MLPs when energy prices move higher. However, the nice thing about many MLPs is that they offer the yield-starved investor a steadily rising income stream no matter which direction oil and gas prices move.

What many people may not realize is that commodity prices don't affect pipeline operators' cash flows as much as energy demand. Instead, their profits depend on the volume of product that gets pushed through their pipelines and other energy distribution systems. As long as demand continues to grow, so will profits.

U.S. energy demand is expected to grow a steady +1.25% annually for the next 20 years, just as it has over the past 20 years. As a result, MLPs should continue to provide a growing income stream for years to come.

MLPs Come In a Variety of Flavors
That said, some energy-related MLPs deliver more predictable earnings and dividends than others. Pipeline operators like Kinder Morgan (KMP) usually generate stable income, but growth tends to be constrained by government regulation on rates.

Meanwhile, propane distributors generally offer more upside potential than pipelines. Their rates aren't regulated, but warm winters or cool summers could affect demand for their product. However, such risk factors are generally short-term aberrations.

And finally, oil and gas leaseholders probably provide the best yields and the most upside potential. Although these firms are more exposed to oil and gas price fluctuations, in today's environment of record-high commodity prices, even the most risk-averse investor might want to take a closer look at oil and gas leaseholders like Dorchester Minerals (DMLP).

More Pipe Means More Profits
With most of the profits going to shareholders, what will drive this sector's growth in the months and years ahead? Most MLPs make money by delivering natural gas and petroleum products to the market. The more pipelines, gathering systems, tanks, barges, or royalty interests they own, the more cash flow they can generate.

Their key to growth is buying or building the infrastructure that will ramp up their product capacity. And this group has been doing just that. The five largest MLPs will likely spend over $13 billion on development projects over the next three years, according to investment firm Wachovia.

Growing Institutional Interest
You know an industry is getting hot when major financial institutions start piling into it. For years, master limited partnerships were owned almost exclusively by individual investors. Institutional investors held less than 5% of these securities.

Now that's changing, and institutions are homing in on this once overlooked sector. Mutual funds were recently given the green light to hold more MLPs in their portfolios. In October 2004, Congress passed a law allowing funds to hold up to 25% of their assets in MLPs, whereas previously MLPs could account for no more than 10% of their assets.

Closed-end funds have been quick to the scene. Institutional investors like Kayne Anderson and Fiduciary have invested some $3 billion over the past two years to develop several new closed-end funds dedicated to master limited partnerships.

And more funds are about to come to market. Just this summer, two financial giants, Citigroup and Alerian, each launched their own MLP indexes. These benchmark indexes are likely precursors for new funds that will be hunting for MLP investments. As more and more institutional money chases this small group of stocks, the buying pressure should send share prices higher.

Benefiting from Stable Interest Rates
Master limited partnerships generate stable cash flow whether interest rates move up or down. However, just like every other income-paying asset class, MLPs compete directly with lower-risk fixed-income investments. If lower-risk bonds offer equally-attractive returns, then investors will rotate money out of higher-risk MLPs and into lower-risk bonds.

Historically, the yield offered by MLPs has been about 2% higher than that of the 10-year Treasury. With 10-year Treasuries yielding 4.8% and MLPs yielding 6.2%, right now that yield difference still sits at a healthy 1.4%, providing investors with plenty of incentive to invest in MLPs.

Taxes are Complex but Funds Can Help
Most MLP distributions are comprised of about 20% net income and 80% return of capital (which is really just an allowance for depletion or depreciation). The income portion is generally taxed at your ordinary income tax rate. You don't pay taxes on the return of capital portion until you sell the security, making MLPs ideal for long-term investors.

Return of capital distributions lead to a reduction in your cost basis. For example, if you pay $50 a share for an MLP and receive a $5 return of capital distribution this year, then the cost basis of your shares will decline to $45. Say you sell the shares next year at $55 a share. You will be taxed at your ordinary income tax rate on the $10 in capital gains ($55 less $45).

If the owner of the security passes away, the reduced cost basis is stepped up to the current share price, and the heirs don't pay taxes on either the capital gains or the ordinary income portion of the distribution. That makes MLPs good for estate planning purposes, since they don't trigger a tax liability for your estate.

There is one glitch with MLPs, however. Individual MLPs aren't suitable for individual retirement or other tax-deferred accounts because they generate a type of income called "unrelated business taxable income," or UBTI. If your retirement account earns more than $1,000 of this income, then you'll end up paying taxes on it. As a result, you probably want to hold MLPs in a taxable (regular brokerage) account.

You can skirt around the UBTI issue by opting for a closed-end fund that invests in master limited partnerships, such as Kayne Anderson Energy Total Return (KYE). These funds handle the complexities of K-1 tax forms, Schedule E: Supplemental Income and Loss, and out-of-state returns that may need to be filed for individual MLP securities.

Funds simply send you a 1099-Div form to file your investment income. The dividends you collect from these closed-end funds are generally taxed as ordinary income, but unlike individual MLPs, you can hold these funds in a tax-deferred IRA or Roth account without incurring additional UBTI.

Although management fees take a bite out of their yield, thanks to their tax and diversification benefits, MLP funds remain an excellent choice for many investors.

50 Major Master Limited Partnerships
MLPs are as varied as the resources they bring to market. However, they generally fall into four main groups: pipeline carriers, propane distributors, coal leaseholders, and oil and gas leaseholders. Below you will find a list of the 50 largest MLPs in the benchmark Alerian MLP Index.

MLP Closed-End Funds
Investors can also choose from seven closed-end funds specializing in MLPs, as shown below.

Here's a closer look at our favorite individual master limited partnerships and MLP funds . . .

Important Note: Throughout the remainder of this article, we provide a closer look at our favorite individual MLPs and MLP funds from the tables above. However, in order to view the remainder of this article, you'll need to subscribe to our premium income-oriented newsletter -- High-Yield Investing. After you subscribe you'll receive immediate access to this full article, as well as our monthly High-Yield Investing newsletter and a host of additional premium content. Please visit one of the following links to continue...

Carla has been employed in the investment industry for more than two decades. In addition to her work as a writer for several other nationally recognized financial publishers, her previous experience includes a position as President of a well-respected investor relations firm. She has also been writing shareholder reports for public companies (annual reports, speeches, corporate profiles, slide shows, etc.) since 1980.

A highly successful investment analyst, Carla specializes in high-yield, income-paying stocks. In that pursuit, she's always mindful to select companies that not only pay rich dividends, but that also have the potential to deliver strong long-term capital gains.

On the educational front, Carla holds both MBA and Ph.D. degrees. When she's not watching the market, she's teaching business courses at the college level and managing several million dollars in portfolio assets.

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