A Popular MLP ETN Tries To Fend Off Oil's Decline

With their high-dividend yields and perceived lack of correlation of to oil prices, master limited partnerships (MLPs) and the corresponding exchange traded products have been favored destinations for income investors as the Federal Reserve has persistently kept interest rates low over the past several years.

However, MLP exchange traded funds and exchange traded notes (ETNs) have defied the conventional wisdom that the asset class can remain sturdy even as oil prices slide. As the United States Oil Fund (NYSE: USO) has plunged more than 56 percent over the past year, the JPMorgan Alerian MLP Index ETN (NYSE: AMJ), the largest MLP ETN, is off 24 percent, reminding investors that if an asset class is related to oil, it has likely been imperiled for at least a year.

“There’s no question that they are more insulated than broad energy funds when it comes to energy-price movements, but they do end up feeling some pain,” said Morningstar analyst Robert Goldsborough in a recent note. “About one fourth of industry cash flows are commodity-sensitive, so as oil prices declined relative to natural gas prices, gas processing margins contracted, weighing heavily on the cash flows of MLPs that have non-fee-based gas processing businesses.” 

AMJ's tempting yield of 4.7 percent, which is more than double the yield on U.S. Treasurys, is far from a free lunch. The ETN has a standard deviation of almost 16.6 percent, which is close to double that of S&P 500 ETFs. Plus, AMJ charges 0.85 percent per year, a high fee for a passively managed product.

Other Risks

There are other risks as well. As an ETN, AMJ differs from traditional ETFs in that it is treated as a debt instrument and its credit-worthiness is backed by that of the issuing bank. Fortunately, J.P. Morgan Chase (NYSE: JPM) is one of the most financially sound large U.S. banks. Another issue with ETNs is limited creations, which can have significant impact on investors' buying and selling prices.

“The ETNs are subject to a maximum issuance limitation of 129,000,000 ETNs, which may cause the ETNs to trade at a premium relative to the indicative note value.  Investors that pay a premium for the ETNs could incur significant losses if that investor sells its ETNs at a time when some or all of the premium is no longer present. We issued the remaining 11,050,000 ETNs authorized for issuance on June 19, 2012,” according to JP Morgan.

Or as Morningstar puts it, AMJ's capped creations have left the ETN functioning like a closed-end fund.

Those factors have not prevented nearly $4.9 billion from flowing into AMJ. The ETN holds some income investor favorites, include Enterprise Products Partners (NYSE: EPD), Energy Transfer Partners (NYSE: ETP) and Magellan Midstream (NYSE: MMP), among others.

“Over the longer term, prospects for the energy MLP industry are generally favorable. While lower energy prices may slow project development and may limit energy MLPs' ability to keep their project backlogs full, the vast majority of MLPs' cash flows are linked to long-term, fee-based contracts, supporting relatively stable cash flows despite market tumult,” according to Morningstar.