Market Overview

MLPs: A Barbell Approach

Are you aware that MLPs, or Master Limited Partnerships, have been the best performing global asset class over the last 3, 5, and 10 year periods? Their strong performance, high yields, and inherent tax advantages have caused MLPs to grow from $30 billion in investment in 2003 to $250 billion today. Their structures and the tax implications of owning them make MLPs a bit more complicated than a common stock or vanilla bond, but they are particularly efficient investment vehicles for individual investors.

An MLP combines the tax benefits of a limited partnership with the liquidity of exchange traded securities. Specifically, MLPs are able to avoid corporate income taxes because of their partnership structure. They pay out "quarterly required distributions (QRDs)" to limited partners, or unitholders (the investor).

These distributions are then taxed at the limited partner's marginal rate and they are allowed to record a pro-rated share of the MLPs depreciation on his or her own tax forms, thereby reducing tax liability. Many individual investors, however, hold MLPs in tax deferred accounts. In order to learn more about the unique tax treatment of MLPs, interested investors should consult their financial adviser.

Most MLPs operate in the energy industry, but some real-estate partnerships as well as finance companies also qualify to use this special structure. In general, energy MLPs own assets such as pipelines, natural gas, gasoline, oil, storage, terminals and processing plants. This provides them with very stable cash flows which are less volatile than many other businesses. The relative stability of this asset class along with their attractive yields make MLPs particularly compelling for investors who may be concerned about market volatility in 2012.

Many large, established energy MLPs have been red-hot in 2011, with returns exceeding the S&P 500 by a very wide margin. Other smaller, newer, and less established ones have lagged the broader market and are offering extremely compelling yields at current levels. One approach to investing in MLPs in the New Year that readers may want to consider is a barbell strategy which offers a strong overall yield, the opportunity for capital gains, and a tailored risk profile.

Such a strategy may be implemented in order to take advantage of dislocations which have occurred among specific MLPs amid the rocky 2011 market environment. In particular, large partnerships such as Kinder Morgan Energy Partners (NYSE: KMP), Williams Partners (NYSE: WPZ), and Magellan Midstream Partners (NYSE: MMP) have performed very well in 2011 while smaller MLPs have lagged, which has pushed their yields higher.

The idea of a barbell approach is to select a portfolio of individual MLPs tailored for personal risk tolerance, yield, and potential for capital gains. Creating a portfolio of large, well-established, lower yielding MLPs and smaller, riskier, high-yielding MLPs may enable investors to generate better risk-adjusted returns than just selecting a few well-known names or focusing only on MLPs with unusually high yields. Below, we take a look at a collection of MLPs based on their size, year-to-date performance, and current yields.

Kinder Morgan Partners - This is a very well-known MLP which has been a tremendous performer. The partnership's current market cap is $27.36 billion and KMP has risen around 17% in 2011, with all of the gains coming in the last 3 months. Over that time period, KMP is up almost 20%. At current levels, KMP is yielding a respectable 5.65%.

Enterprise Products Partners (NYSE: EPD) - Enterprise is a massive MLP with a sterling record of providing strong returns to limited partners. Currently, EPD is sitting near all-time highs and has a market cap of nearly $40 billion. Year-to-date, EPD has risen 8.65% and is yielding 5.42%.

El Paso Pipeline Partners (NYSE: EPB) - This is another very well-established MLP which has a track record of rapidly increasing its distributions to investors. Since it began trading on the NYSE in 2007, El Paso has increased its quarterly distribution to unitholders from $0.13 to $0.49. Year-to-date, EPB is up 0.24% and currently has a market capitalization of $7.83 billion. The MLP yields 5.85% at current levels.

Williams Partners - This is one of the top performers in 2011, rising more than 27%. WPZ has been steadily increasing its quarterly distribution since going public in 2006 and is quite large with a market cap of $17.24 billion. WPZ currently is yielding 5.04%.

Magellan Midstream Partners - MMP is up more than 17% in 2011 and has rallied more than 10% in the last 3 months. MMP has a market cap of $7.47 billion and yields 4.83%.

Enbridge Energy Partners (NYSE: EEP) - Enbridge has gained a respectable 1.57% year-to-date and has a long track record. Its current market cap is $8.65 billion and it yields 6.72%. Like the other high-quality names above, EEP has been moving strongly higher since October, gaining more than 17%.

Energy Transfer Partners (NYSE: ETP) - ETP is a large MLP which has displayed great long-term performance. Year-to-date, ETP is down 11.89% which has pushed its yield up to an attractive 7.83%. The MLP has a market cap of $9.57 billion at current levels.

The above names represent a good cross-section of blue-chip MLPs. Below, we will look at some smaller, less established MLPs with terrific yields that also have the potential for strong price appreciation in 2012.

Inergy (NYSE: NRGY) - This name has been hit hard in 2011, falling around 38%. While this is bad news for current limited partners, it has pushed NRGY's yield up to 11.60%. The decline is most likely attributable to net losses which NRGY reported in Q2 and Q3. Analysts are projecting that NRGY will return to profitability this quarter. The MLP currently has a market cap of $2.90 billion.

Ferrellgas Partners (NYSE: FGP) - This MLP has also been hard hit in 2011, falling almost 23%. It has a smallish market cap of $1.50 billion and yields 10.26% at current levels. Unlike many other high yielders, however, FGP has a long track record.

BreitBurn Energy Partners (NASDAQ: BBEP) - This MLP has fallen 10.58% in 2011 and is small, with a market cap of $1.06 billion. It offers a very attractive 9.66% yield at current levels. If the market posts a strong 2012, MLPs such as BBEP could post some very impressive returns as investors get more comfortable taking risk.

QR Energy Partners (NYSE: QRE) - Year-to-date, QRE has fallen 2.29%. The MLP has a market cap of $702.78 million and yields 9.66%.

Global Partners LP (NYSE: GLP) - This MLP is the smallest on the list with a market cap of just $489 million. It began trading on the NYSE in 2005 and is currently yielding 8.92%. In 2011, GLP has fallen a little more than 18%.

This list is by no means exhaustive. It is meant to provide investors with a starting point for becoming acquainted with MLPs as an asset class while also highlighting some specific names. Readers who are interested in applying a barbell approach to investing in MLPs should be sure to do their due dilligence on each specific security that they choose for a portfolio and also consult their financial adviser.

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