Pipeline to High Income

Hedge-fund selling has depressed prices of municipal bonds, bank-loan securities and all sorts of mortgage instruments. Many energy-related master limited partnerships have also taken an undeserved pounding because of hedge-fund shenanigans.

I emphasize the word "undeserved." If you're looking for high and reliable income, buy these MLPs now.

Shares of pipelines and energy-storage facilities, which pay high yields because they are structured as MLPs, have sunk 20% since last summer. The decline accelerated in recent weeks. The most-widely-followed index for the category, the NYSE Alerian MLP Index fell 7% in March (for more data, visit www.alerian.com). That was the index's worst month in four years and one of its five worst since its establishment 12 years ago.

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Yet there's nothing wrong with the businesses of moving, gathering and storing oil, natural gas and refined fuels. The selloff in their shares is all about "fear and panic," says Gabriel Hammond, managing partner of Alerian Capital, a Dallas investment firm that specializes in MLPs.

Hammond says most pipeline partnerships are small, with market values of less than $2 billion. Many are spinoffs from larger energy companies and tend to be ignored by Wall Street. The small size and thin trading volume make some mutual funds and other institutional investors skittish in this volatile market climate, which favors large, blue-chip companies.

Hammond adds that pipelines and storage infrastructure are capital-intensive businesses. Like utilities that borrow heavily to acquire and build more power plants, pipelines are constantly upgrading and expanding the system of "toll roads" for the movement of energy. General anxiety that credit will be scarce or more expensive in the years ahead weighs on the shares.

But there's a more immediate and sinister problem, which is why analysts at Wachovia Securities call the March fall "a disconnect with fundamentals." A bunch of hedge funds -- one of which is said to have leveraged $2 billion of MLP shares -- recently had to dump positions to raise cash. In this narrow, relatively illiquid sector, distress sales cause fast and furious losses.

The result: a leap in the average yield for the category to 7.25%, two percentage points higher than it was last year and, more critically, close to four percentage points above the ten-year Treasury yield.

The widest spread on record between the Alerian index and ten-year Treasuries was 4.25 points, in November 2002. That gap preceded a monster rally in the pipeline shares. They doubled from that point to mid-2007 while also generating steadily rising dividends. Analysts and financial advisers compare the run to the glory days of real estate investment trusts, when both property values and dividends soared and 30% annual total returns were commonplace.

REITs and pipeline MLPs are cousins because both must pass through nearly all their earnings to investors or else get taxed as corporations. But the similarities end there. REIT returns are subject to the cyclical real estate business and the willingness of giant investors to outbid one another for properties.

Pipelines, storage tanks and underground gas fields are a steady, regulated sector, more closely comparable with old-style electric utilities. The Federal Energy Regulatory Commission guarantees interstate pipeline operators annual inflation-adjusted rate increases. And although Americans may drive less because of the high price of gasoline, they won't cut back enough to materially affect the cash flow and earnings of these MLPs.

Moreover, REITs are much more closely correlated to the overall stock market than shares of pipelines and storage tanks. In most sideways and bear markets, the MLPs hold up just fine.

This leads to the obvious question: When does the hedge funds' panic selling subside?

Soon, says Hammond. Lehman Brothers, Wachovia and Morgan Keegan are also all convinced the selloff went too far. And some money managers have now decided to take a look at pipelines. "We love 'em," says Bob Westrick, president of WNA Wealth Advisors in Hinsdale, Ill. He's substituting pipelines for REITs in some of his customer accounts.

If all this grabs you, there are three ways to invest: closed-end funds, an exchange-traded note, and the individual issues.

If you want to own these critters inside of an IRA, I strongly recommend that you invest through closed-end funds. That's because MLPs inside of IRAs cause tax complications (rather than getting bogged down in the explanation, I'll just suggest that you Google the matter to find countless explanations from CPAs and tax lawyers).

Kayne Anderson Fund Advisors has two similar and well-diversified closed-ends, Kayne Anderson MLP Investment Company (symbol KYN) and Kayne Anderson Energy Total Return Fund (KYE).

The former must hold at least 85% of its assets in MLPs, so KYN would appear to be more of a pure income fund than its sibling and, therefore, safer. KYE has the leeway to invest in energy royalty trusts and tanker stocks, which generally yield more than pipelines but are inherently riskier and are likelier to vary their dividends more. At its April 7 close of $27.50, KYE has a distribution rate of 7.3%. At $28.78, KYN yields 7%. What's more, KYE currently trades at a 9.4% discount to its net asset value per share, while KYN sells at a 6.16% premium.

On the basis of both yield and discount, KYE seems to have the upper hand. At last reports, its four largest holdings are midstream income securities (the businesses of moving, gathering and storing energy are considered midstream because they're between producers and consumers): Kinder Morgan Management (KMR), Plains All-American Pipeline (PAA), Enterprise Products Partners (EPD) and Enbridge Energy Management (EEQ). All are trading at reasonable, if not depressed prices, and all recently increased their dividends. They'd be fine individual holdings as well as the core of a good fund.

Two other closed-ends do the same thing as Kayne Anderson: MLP & Strategic Equity Fund (MTP) and Cushing MLP Total Return Fund (SRV), and both portfolios should do well once investors are convinced that the hedge funds are done liquidating the shares. But neither fund is even a year old, and the Kayne Anderson funds have shown they can do well in a bull market for the sector and suffer less when the class is falling.

The midstream MLP universe offers lots of proven names if you like to own individual securities. The largest one by market capitalization is Kinder Morgan Energy Partners (KMP), which, among other things, is a partner with ConocoPhillips and Sempra Energy in a project to build a massive new natural gas pipeline from the Colorado Rocky Mountains to the east and southeast. There are several such projects, but there may be room for all of them if the locus of U.S. natural production shifts from Texas and Louisiana to the mountains, as many experts predict.

Kinder's size gives it a good position in the race to get cheap capital, so it could well be a growth stock again as well as a dividend payer. Its year-to-date total return of 7.2% to the plus side is one of the sector's best.

Enterprise is also a mega-sized midstream company and one that has a lot of established pipelines and expansion plans. It's not that easy to differentiate among these stocks except by size. One red flag may be a pipeline or storage MLP issuing a lot of new shares, as some may do to raise capital if they have problems borrowing. That can dilute existing shareholders and potentially weigh down returns.

If you own MLPs in a taxable account, you get a break. MLP distributions are considered to be returns of capital, and therefore not taxable until you sell the shares, at which point they reduce the basis in your investment. (If an MLP sells some assets, such as land, during the year for a profit, that part of your income would be taxed at the favorable capital-gains rate.)

Finally, did I say there was an exchange-traded note? Yes, and the strange thing is that it's got a Bear Stearns connection. It's called BearLinx Alerian MLP Select Index ETN (BSR). The note, which Bear issued last summer, seeks to track the Alerian select index, which includes the 25 largest of the 50 or so securities in the midstream energy category.

ETNs are similar to the more-familiar exchange-traded fund. But unlike an ETF, which invests in a basket of securities, an ETN is, in effect, a bond. It represents a promise from the issuer that it will make good on the terms inherent in the note's objective. If a mutual fund's sponsor goes bankrupt, its directors can simply hire a new adviser. With an ETN, there's a theoretical chance that the issuer can renege on its obligation.

With JPMorgan Chase on the verge of buying Bear Stearns, BearLinx Alerian is likely to survive, albeit with a new name. It's a perfectly sensible idea for investing in a subset of the pipeline and energy infrastructure stock universe. But an ETN is so hard to understand -- just try to read the prospectus -- that I think most investors are better off buying one of the closed-end funds.

If you aren't investing in an IRA, I believe the best approach is to buy the MLPs directly. The businesses are essential and the values are right. I'm confident that over the coming year midstream energy partnerships will provide a few percentage points of capital growth to go with 7% worth of income.