How Higher Interest Rates Impact MLPs

Higher interest rates have a number of implications for investors in master limited partnerships (MLPs).

Record low interest rates over the last decade have created major challenges for income investors, who through 2007 had enjoyed generous yields on risk-free investments such as savings accounts, money market funds, CDs, and U.S. Treasury bonds.

Today, many of those assets offer paltry or even negative interest rates, helping explain why MLPs have become increasingly popular during this time of low interest rates.

These (generally) energy-focused infrastructure stocks are structured in such a way as to pay generous and often growing yields.

Thus they have become a major staple in many investors’ dividend retirement portfolios.

However, with interest rates potentially set to rise significantly over the next few years, many MLP investors are worried what this means for the MLPs in their portfolios.

Let’s take a look at why MLPs are so interest rate sensitive, and more importantly how MLP investors should position themselves going forward.

Like real estate investment trusts (REITs), MLPs are pass-through entities, meaning that they pay no corporate taxes because they pay out the majority of their distributable cash flow (DCF – similar to free cash flow for MLPs) as distributions (i.e. tax-deferred dividends).

However, this has important ramifications for the industry’s business model.

Specifically, because MLPs retain very little cash flow for growth, they need to constantly tap external debt and equity markets (i.e. sell new shares) in order to complete new projects to grow DCF and payouts over time.

This reliance on external capital sources means that MLPs generally carry high amounts of debt on their balance sheets and are frequently selling new units (the MLP equivalent of shares).

Thus, with higher interest rates likely meaning higher debt costs moving forward, most MLPs will see higher costs to fund new projects and refinance existing debt.

Additionally, the 2017 tax reform act placed a new limitation on interest expense deductions. Specifically, MLPs (as well as many other types of large businesses) are no longer allowed to fully deduct interest expense, instead capping the deduction at 30% of adjusted taxable income. 

Tax reform brings a number of puts and takes for the industry, but this component could make MLPs more sensitive to interest rates going forward. Time will tell.

And when it comes to unit prices, which are an important factor in an MLP’s ability to grow, here too rising rates represent a significant risk.

That’s because, as interest rates rise, yields on risk-free investments such as money market funds and Treasury bonds will also rise.

As a result, more competition is created for new capital that, up until now, MLPs haven’t had to contend with.

Since the financial crisis, MLPs have been thought of by many investors as bond alternatives, owing to their tollbooth-like business model (i.e. steady cash flows secured by long-term, fixed-fee contracts).

And so, as with bonds, higher interest rates mean that investors are likely to demand higher yields on MLPs going forward. As a result, unit prices could fall (yields rise when prices fall).

However, while higher yields are great for new investors who can lock in an attractive yield on cost, it also means that an MLP trying to raise a certain amount of money to fund its growth will need to sell more units because the price of each unit is lower.

In other words, future equity sales will likely result in more dilution. Accretive growth opportunities, in which the increase in DCF outweighs the increase in unit count (increasing DCF per unit and allowing sustainable payout growth), will be harder to come by.

This is especially true because most midstream (e.g. energy transportation, processing, and storage) MLPs have a general partner who serves as sponsor and manager of its assets.

General partners own not just a large portion of the limited units (i.e. what investors buy), but also incentive distribution rights (IDRs).

IDRs are highly profitable for the general partner because they grant it the right to up to 50% of marginal DCF above a certain distribution level.

While this creates an incentive for the sponsor to grow the MLP’s distribution quickly, it also raises the MLP’s cost of capital because only half of any new projects’ cash flow ends up going to investors.

In fact, because of IDRs, MLPs are more interest rate sensitive than REITs, which also rely on external debt and equity capital and are thus very rate sensitive as well.

MLPs are more sensitive to higher interest rates because of one other important factor that REITs don’t have to deal with – commodity prices, specifically oil and gas.

Since oil and gas are priced in U.S. dollars, a strengthening dollar can cause the price of oil and gas to decline.

Why would higher interest rates cause the dollar to increase?

Sluggish economic growth in other economies, such as the U.K., the E.U., and Japan, has caused the central banks there to keep interest rates very low or even negative.

Higher interest rates in the U.S. attract foreign capital because people from around the world are eager to invest in higher rate U.S. assets such as risk-free Treasuries.

That in turn requires converting their foreign currency to dollars and raised demand for the greenback. In addition to the supply headwinds hurting the price of oil and gas, the stronger dollar could also keep a lid on prices, which are still trading well below their pre-oil crash levels.

In recent years, low energy prices have decimated the balance sheets of oil companies, resulting in massive cuts to capital spending, lower production, and decreased demand for midstream services.

While the majority of most MLP’s DCF is from long-term contracts, not all of these contracts have minimum volume provisions, meaning that many MLPs have more commodity exposure than investors realize.

This is one reason, for example, why pipeline giant Kinder Morgan (KMI) was forced to slash its dividend by 75% back in 2015, after its acquisitions of its MLPs left it with an unsustainable debt load and its low share price created a self-perpetuating liquidity trap (i.e. unable to sell shares at high enough levels to raise new capital).

Some MLP customers are no longer financially healthy enough to honor the long-term contracts they initially signed as well, creating additional risk.

Since many MLPs, such as Energy Transfer Partners (ETP), took on massive amounts of debt back when oil was over $100 per barrel, higher debt service costs, as well as a lack of access to cheap equity capital (due to low unit prices), have forced dozens of highly leveraged MLPs to cut their distributions over the past few years.

While many MLPs are facing a potential perfect storm in the form of persistently low energy prices and rising interest rates, which will mean higher debt and equity costs, that doesn’t mean that investors can’t still earn reasonable returns from parts of this industry.

However, it does mean that you need to be very selective in terms of what MLPs you buy. Blue-chip midstream MLPs such as Enterprise Products Partners (EPD) and Magellan Midstream Partners (MMP) have long and proven track records of being able to grow steadily in various economic and interest rate environments.

These steady payout growth records have allowed high-quality MLPs such as Enterprise and Magellan to generate generous and steadily rising income over the years, while delivering strong total returns.

What’s the key to such impressive long-term success? Pretty much the same thing as for most great dividend growth stocks, such as dividend achievers, aristocrats, and kings.

Specifically, shareholders are most often rewarded by long-term focused and conservative management teams that take a slow but steady approach to payout growth.

For example, unlike many MLPs such as Williams Partners (WPZ), which tried to grow too quickly and overextended itself with debt, Enterprise and Magellan have historically had very safe and sustainable debt levels.

That’s thanks to their strategy of maintaining relatively high distribution coverage ratios (Distribution / DCF per share), which allowed them to retain more cash flow to reinvest into future growth.

In turn, they were less dependent on external debt and equity markets, which is why both MLPs today have BBB+ credit ratings, the highest of any MLP in America. As a result, both companies maintain strong access to relatively cheap debt and equity capital.

In fact, the very thing that has allowed them to make such strong investments (consistent payout growth no matter what energy prices, interest rates, or the economy are doing) is why Wall Street has given these MLPs valuation premiums that continue to supply them with plenty of liquidity to keep growing despite rising interest rates and the ongoing oil crash.

Now that we know the three ways that MLPs can be affected by interest rates, it’s important to note that not all MLPs are created equal.

For example, the most interest rate sensitive MLPs will be those such as Williams Partners (WPZ), which have extremely high debt levels (and thus need to keep rolling over debt over time), relatively high commodity exposure, and general partners that siphon off IDR fees, in this case Williams Companies (WMB).

Less interest rate sensitive MLPs are those that are conservatively run with low debt levels and financially strong customers, and long-term contracts backed by minimum volume provisions and fixed fees. 

Also less sensitive are certain Liquefied Natural Gas (LNG) tanker MLPs. These MLPs are less sensitive to interest rates because low natural gas prices actually increase the demand for LNG imports from nations such as China, India, and Japan, where natural gas prices are higher than in the U.S.

Demand for natural gas-fired power plants is growing strongly due to concerns over pollution from coal-fired plants, and the 20-year, fixed-fee contracts underpinning this industry mean that these MLPs have particularly good cash flow predictability.

Even less sensitive are those few midstream MLPs that have bought out their general partners and thus have no IDRs and very low costs of capital (and the easiest time finding profitable growth projects).

These include names such as: Enterprise Products, Magellan Midstream Partners, and Genesis Energy Partners (GEL).

Finally, keep in mind that not all MLPs are in the energy sector, meaning that they have no exposure to cyclical energy prices.

This includes stocks as Terra Nitrogen (TNH), Ciner Resources (CINR), and Enviva Partners (EVA), that produce fertilizer, soda ash (for baking soda), and wood chips (for mulch), respectively.

Of course, these are also commodity products, so they face cyclical prices over time.

However, often these cycles make for good hedges against energy midstream MLPs. That’s because low energy prices mean lower input costs since fertilizer is made with natural gas and wood pellets are dried with natural gas fired ovens.

Still, their high payout ratios, large debt loads, and variable distributions do not make these investments appropriate for the fainthearted. 

Given that most midstream MLPs are sensitive to interest rates in several different ways (higher debt costs, higher equity costs, and lower energy prices), many investors might think that it’s best to avoid the sector entirely.

However, that’s not necessarily true.

For example, from June 2004 through June 2006 the Federal Funds Rate increased 425 basis points to reach 5.25%. Despite rising rates, MLPs returned approximately 39%, according to Alerian. 

Furthermore, energy prices are impossible to predict, and the very cyclical nature of MLPs can be an asset to patient, long-term investors willing to stomach some price volatility.

The sector can occasionally offer up high-quality, high-yield MLPs at discounted prices, which means locking in a solid yield on cost and setting the foundation for a growing income stream.

But wouldn’t it make sense to simply buy MLPs when rates are high (and presumably unit prices the lowest), then sell at the top of the next interest rate and commodity cycle?

In other words, couldn’t market timing yield even better returns over time?

No. The key to successful, long-term MLP investing is the same as good dividend growth investing in general. Specifically, make a well-constructed investing plan, one based on your own goals, risk tolerance, and time horizon.

Next, do your research and only buy the highest-quality MLPs (of which there are extremely few) – those with solid balance sheets, and conservative management teams that have shown an ability to grow investor wealth over time in all types of interest rate, commodity, and economic conditions.

Finally, buy when they are at reasonable prices, hold for the long term (only sell if the investment thesis breaks), add on dips, and reinvest the distributions.

While this may seem like an overly simplistic approach, history has shown that it’s all you need to maximize your long-term returns and reach your financial goals.

The other key is to maintain a diversified portfolio. MLPs have unique risks because of their high payouts, and these companies (even the best ones) can run into trouble if access to capital markets becomes more expensive or harder to come by.

Every dividend stock industry is slightly different, with its own inherent risks and challenges.

However, almost every sector has quality industry leaders that can make for reasonable long-term dividend growth investments.

This is especially true during times when investment sentiment sours and creates appealing valuations and healthy yields.

When it comes to higher interest rates and their potential negative impact on MLPs, you need to remember the cardinal rules of successful dividend growth investing: do your homework, buy high-quality companies, hold for the long term, buy the dips, and reinvest the distributions.

As long as you follow this strategy, then short-term MLP market corrections, whether from rising rates or fluctuating energy prices, can potentially represent opportunities.

However, it can't be emphasized enough how important it is for income investors to stay diversified, remain very selective, and be aware of the unique risks faced by almost every MLP (access to debt and equity financing). There is no such thing as a free lunch or a risk-free, sky-high yield.