The Pros and Cons of MLPs

Pipeline

Most stocks are fundamentally the same kind of investment: they’re shares of ownership in a corporation. There are a few exceptions, however. One is “Master Limited Partnerships” (MLPs), which are popular among many investors because they tend to have very high yields. MLPs trade on stock exchanges just like other stocks, but there are important differences from both a legal perspective and an investment perspective.

MLPs are mostly energy companies, such as companies that operate the pipelines that transport oil and gas across the US. They’re technically “partnerships” rather than “corporations” so their profits can go straight to their shareholders without being taxed at the company level. As a result of the tax laws related to this difference, MLPs distribute a large portion of their profits to shareholders, making them very high-yielding investments. They also have additional tax advantages: for example, a large portion of the distributions are usually taxed when you sell the investment rather than immediately when the distributions are paid.

Of course there are plenty of drawbacks to MLPs as well. Since MLPs are generally energy companies, having too much exposure to them can make your portfolio vulnerable to a downturn in the energy sector. Furthermore, since MLPs distribute almost all of their profits to shareholders, they regularly need to raise new money to maintain and grow their business. This can make them sensitive to problems in financial markets: many MLPs struggled to raise funds at attractive rates during the financial crisis.

In sum, MLPs can be an effective way for investors to generate income from their investment portfolio and get some tax benefits to boot. But like most types of investments, having too much exposure to MLPs can create substantial risks.

How Long Can Bond Yields Stay Low?

10Y US Treasury Yield

Despite numerous predictions that bond yields would soar (and therefore bond prices would fall), yields have actually fallen so far in 2014. After rising from record lows last year, the yield on 10-year US treasury bonds is currently around 2.5%, still far below its typical historical range. How long can bond yields stay so low? The answer is “possibly a very long time” based on the experiences of other countries.

The country that has the most experience with low bond yields is Japan. Following its real estate and stock market collapses a quarter century ago, interest rates started declining, with the yield on 10-year Japanese treasury bonds falling below 2% in the late 1990’s. It’s stayed below 2% almost constantly ever since, as weak economic growth and a low (even sometimes negative) inflation rate have given investors little reason to ditch the perceived safety of the country’s government bonds.

10Y Japan Treasury Yield

It’s unlikely that the US will experience such a lengthy period of such low yields. There are a few key factors working in favor of stronger economic growth for the US economy, such as more favorable demographic trends and an inflation rate that has mostly stayed in positive territory. In theory US policymakers should also be able to learn from Japan’s long stagnation to help avoid a similar fate.

Still, there’s no rule of economics that says that interest rates have to revert toward their average historical levels. The lesson from Japan’s experience should be that if economic growth remains weak and the inflation rate remains subdued (and there are plenty of economists who have this outlook), bond yields could remain low for a very long time.