On the income side, many of the top high-yielding MLPs offer dividends that you just can’t get from other investments. Of the 50 companies in the Alerian MLP index, the industry benchmark, several offer yields of 8.5% or higher.
The best part is you don’t have to sacrifice capital gains to get those high yields. Over the past five years, the Alerian MLP index has outperformed the S&P 500 by a wide margin, gaining 69%, compared to just 36% for the S&P 500.
How the Top High-Yielding MLPs Reward Investors
MLPs are limited partnerships that trade on the major stock exchanges, just like any stock. They can be easily bought or sold through any broker at the same commissions you pay for any stock transaction. Many MLPs operate in the energy business, particularly operating midstream assets like pipelines, storage and processing facilities.
As we point out in detail in our exclusive free report, “Master Limited Partnerships: High Yields and Low Taxes,” one reason why the high-yielding MLPs can offer steadily rising distributions to investors is that they don’t pay taxes at the corporate level. Instead, they pass through the majority of their income to investors in the form of regular distributions. Each investor is responsible for paying tax on their share of distributions received. This avoids the double taxation that applies to corporate dividends.
But that’s just the beginning. The Internal Revenue Service generally treats 80% to 90% of the distribution you get from MLPs as a return of capital, which limits your current tax liability. Rather, the amount paid is subtracted from the cost basis of an investors partnership units (they aren’t called shares); taxes are due as a long-term capital gain when you sell.
In other words, 80% to 90% of the distribution you receive from an MLP is tax-deferred. The remaining piece of each distribution is taxed at normal income tax rates, not the special dividend tax rate.
3 Keys to Spotting the Top High-Yielding MLPs
Here are three factors to keep in mind when looking for the best high-yielding MLPs to add to your portfolio:Look for a history of distribution growth. Consistently growing payouts not only increase your income stream, they’re also the surest catalyst for higher MLP unit prices over time.
When looking for MLPs to recommend in our MLP Profits investment advisory, we prefer to see management lift the distribution each quarter, or at least once in the past 12 months.
Focus on the underlying business: Distributions are obviously important, but to spot the MLPs that are most likely to give you safe income, it’s absolutely essential to look beyond yield and closely scrutinize an MLP’s fundamental operations.
Chasing yield is a mistake that many investors make, and it’s far from new. In a March 1987 Wall Street Journal article about MLPs, Barbara Donnelly wrote, “Investors are focusing too much on yield, ignoring whether the underlying business can really support such high payouts.”
“Years later, investors are still prone to this mistake,” our research team wrote in a February 3, 2012, article. “Even the financial crisis and stock market implosion of 2008 and early 2009 chastened many about the dangers of reaching for high-yielding stocks, many continue to pursue the same strategy in an effort to recover the wealth they lost back then.”
Fee-based income provides stability: MLP income based on fee-for-service is not directly impacted by energy prices. As such, it’s steadier and more reliable in times of economic weakness. Best of all is revenue that comes from capacity payments. That is, the customer pays whether they use the pipelines, energy storage or processing facilities or not.
The more an MLP relies on fee-based income, the more secure its distribution. Consequently, under our MLP Profits Safety Rating system, we award one point for any MLP that derives 75% or more of its revenue from fee-based businesses, such as ownership of pipelines, energy processing facilities or anything else that generates steady revenue whether oil is at $100 or $25 a barrel.
Bonus tip: Earnings aren’t the best measure of MLP performance. A more meaningful measure for MLPs is distributable cash flow (DCF). To calculate DCF, you simply add all non-cash charges back into the earnings figures and then subtract a measure known as maintenance capital. Maintenance capital is simply a measure of the total cash investment needed each year to maintain an MLP’s assets in good working order.