The City National Rochdale High Dividend Income strategy focuses on stocks with an attractive yield. Through fundamental, “bottoms-up” equity research, our team looks to gain confidence that: 1) the dividend will be maintained, and 2) it will grow over time. In that context, do pipeline Master Limited Partnerships (MLPs) belong in our high dividend strategy, given weak energy prices, and their recent volatile stock performance?
Pipeline MLPs (also known as “midstream” companies) are engaged in the transportation of energy, such as natural gas, natural gas liquids (NGLs), or oil. Many MLPs offer attractive dividend yields derived from revenues based on fee-based tariffs through contracts that are regulated by the Federal Regulatory Energy Commission and indexed to the Producer Price Index. Historically, these revenues have been very stable and utility-like. MLPs are a “pass-through” business structure that allows the companies to distribute their income to shareholders while avoiding taxes at the partnership level. This considerable tax advantage is, by law, only available to domestic energy companies.
Due to the nature of their long-term contracts, midstream pipe-line companies generally do not have direct exposure to the price fluctuations of the commodities they transport. In other words, if oil or natural gas prices fall by 25%, for example, the companies’ revenues are not immediately affected and, all else equal, should remain stable. However, over longer time periods, MLPs can be affected by reduced production activity, which means less oil or NGLs to transport, and therefore lower revenues. There is also “counterparty” risk – given drastically lower energy prices, might the producers using the pipelines go out of business and, if so, can the volume in the pipelines be maintained? An additional concern is access to capital markets. With the decline in stock prices and increase in debt costs, what has happened to MLPs in terms of their cost of capital and ability to access capital?
The primary concerns of future growth prospects, counterparty risks, natural gas liquids (NGLs) (or other commodity) exposures, and capital costs (as well as access) are all aspects of our ongoing analysis of the pipeline sector, no matter the market conditions. And, although our portfolio consists of stocks in sub-sectors that mitigate these risks, in times of heightened volatility the prices of MLPs can closely follow prices in broader energy markets. So while the businesses may have solid, recurring pipeline revenues, and are otherwise insulated from the ramifications of falling oil prices, the sector has still been affected by price weakness in energy commodities (primarily oil). This can be seen in the graph of returns in the Alerian MLP Index versus West Texas Intermediate (WTI) oil.
We focus on select pipeline MLPs that we believe can maintain their distributions in an adverse environment such as this one. The factors we have discussed have brought the prices of these select MLPs to attractive levels. When we look at valuations, we see that sector yield, spread to 10-year Treasury, spread to investment grade bonds, price to discounted cash flow (DCF), and enterprise value to EBITDA (earnings before interest, tax, depreciation, and amortization) are all at the most attractive levels of the past five and ten years.
At the same time, we cannot predict what energy prices will do – oil prices may remain low for quite some time. While not over-weighting the sector, we will continue to hold our select names and focus on factors that drive cash flow and distributions. Given the current valuations and yields of our holdings, we expect that both capital returns and distributions will be positive contributors to total return over time.
City National Rochdale, LLC is a Registered Investment Advisor and wholly owned subsidiary of City National Bank.
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Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.
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There are inherent risks with equity investing. These risks include, but are not limited to, stock market, manager, or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices. Investing in international markets carries risks such as currency fluctuation, regulatory risks, economic and political instability. Emerging markets involve heightened risks related to the same factors as well as increased volatility, lower trading volume, and less liquidity. Emerging markets can have greater custodial and operational risks, and less developed legal and accounting systems than developed markets.
There are inherent risks with fixed income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT) and taxable gains are also possible. Investments in below-investment-grade debt securities and unrated securities of similar credit quality, commonly known as “junk bonds” or “high-yield securities,” may be subject to increased interest, credit, and liquidity risks.
Investments in emerging markets bonds may be substantially more volatile, and substantially less liquid, than the bonds of governments, government agencies, and government-owned corporations located in more developed foreign markets. Emerging markets bonds can have greater custodial and operational risks, and less developed legal and accounting systems than developed markets.
Investments in Master Limited Partnerships (MLP) are susceptible to concentration risk, illiquidity, exposure to potential volatility, tax reporting complexity, fiscal policy and market risk. Investors of MLPs are subject to increased tax reporting requirements. MLP investors typically receive a complicated Schedule K-1 form rather than Form 1099. MLPs may not be appropriate investments for tax-advantaged accounts because of potential negative tax consequences (Unrelated Business Tax Income).
As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money.
Returns include the reinvestment of interest and dividends.
Investing involves risk, including the loss of principal. Diversification may not protect against market loss or risk.
Past performance is no guarantee of future performance.
The Standard and Poor’s 500 Index (S&P 500) is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
The Dow Jones Industrial Average Index is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq.
The MSCI EAFE Index is an equity index which captures large and mid-cap representation across developed markets countries around the world, excluding the U.S. and Canada. Developed markets countries in the MSCI EAFE Index include: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the UK.
MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
The Barclays Aggregate Bond Index is comprised of U.S. government, mortgage-backed, asset-backed, and corporate fixed income securities with maturities of one year or more.
Producer Price Index measures the average changes in prices received by domestic producers for their output.
Barclays U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt. Eurobonds and debt issues from countries designated as emerging markets (sovereign rating of Baa1/BBB+/BBB+ and below using the middle of Moody’s, S&P, and Fitch) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind bonds (PIKs, as of October 1, 2009) are also included.
J.P. Morgan’s Corporate Emerging Markets Bond Index Broad Diversified High Yield (CEMBI BD HY) is a market capitalization weighted index consisting of US-dollar-denominated emerging market non-investment grade rated corporate bonds. According to J.P. Morgan, this index limits the weights of those index countries with larger corporate debt stocks by only including a specified portion of these countries’ eligible current face amounts of debt outstanding.
Alerian MLP Index is the leading gauge of large- and mid-cap energy Master Limited Partnerships (MLPs).
Barclays U.S. Corporate BBB OAS Index is the Baa component of the U.S. Corporate Investment Grade index. The U.S. Corporate Investment Grade Index is publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered.
Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.