November 13, 2006 MASTER LIMITED PARTNERSHIPS No. 1
Master Limited Partnerships trade like minus the lowered cost basis) is treated
stocks but act more like fixed income as a capital gain, and a portion is taxed
securities with tax advantages. Though as ordinary income. MLPs are not
they trade on exchanges like the New suitable for tax-deferred accounts such as
York Stock Exchange, Master Limited IRAs because earnings above $1,000 are
Partnerships (MLPs) trade as units, not considered “unrelated business income,”
shares. They currently pay income at which is taxable.
annual rates of 6.5% to 7.5%.
As with any high-yielding instrument, the
Unlike bonds, payments may rise if the attraction of the yield paid by MLPs dips
company grows. And the price of units as interest rates rise. A 7% MLP dividend
could rise. But both of these come with looks better to investors when bonds are
the risk that income or unit price could paying 4% than when fixed income is
drop if the company runs into trouble. paying 5.5%. Interest rate rises can
cause MLP unit prices to fall versus other
Many portfolios see diversification shares. Some MLPs operate in industries
benefits from MLPs. Some MLPs that such as gas pipelines where transmission
passed our screen of certain criteria carry rates adjust for inflation. So if interest
a beta of -0.1 to +0.4. The stock market, rates rise with inflation, chances are
represented by the S&P 500 index, has a dividends paid by the MLP also will rise,
beta of 1.0. The more a security’s beta protecting the units from the price effect
diverges from the market’s, the greater you would expect when other rates rise.
the diversification benefits. That should
translate into lower risk and/or higher Key factors to look for when deciding on
returns for a portfolio. MLPs to buy include:
Distribution coverage. Is the company
Because MLPs throw off partnership generating enough cash flow to cover its
losses, holders of MLP units typically can promised payout? Look for a distribution
defer taxes on much of the yield they ratio above 1.0.
receive. Holders need to file a tax form K- Current payout level. MLPs carry more
1 to capture the details of the partnership risk than Treasuries. They should have
income and losses. yields well above Treasury yields.
Growth in payout. Dividend history will tell
Investors often want to have these you whether the income has grown.
investments in their taxable accounts Debt-capital ratio. If an MLP is deep in
because of tax advantages that accrue debt, it might not be able to maintain
from MLPs. If an investor reaps tax payout if business hits a bump.
benefits from an MLP, selling the units
can generate taxes in the year of the We believe MLPs offer diversification,
sale. Over time, the income payments income and appreciation potential. If you
reduce the cost basis of the investment. would like to discuss them in relation to
When the units are sold, a portion of the your account with us, please call at your
gain (the difference of the selling price convenience.