Should You Buy Shares in a Master Limited Partnership?

Should you buy shares in a limited partnership?Master Limited Partnerships are complicated investments in which you share in the profits from an income-generating business. Most often these partnerships make their money in energy-related businesses. They’re publicly traded and offer certain income tax benefits. They aren’t for everyone, however.

I wasn’t planning to write about Master Limited Partnerships (MLPs) anytime soon, but I feel compelled to comment on a piece written by Michael Brush on MLPs at msn.com today.  Brush is a talented and prolific journalist and I admire his work.  However, I think that this article could use a bit more nuance (or maybe he wrote it with nuance and it was edited out….)

Before I rant, let me explain a bit more about what these investments are.

Unlike corporations, MLPs (and income or royalty trusts) are exempt from paying income tax.  Instead, they are required to pay out 90% of their gross income to the partners – most of their cash flow is paid out annually.  Partners/shareholders typically pay their normal marginal tax rate on up to 20% of the distributions.  Taxes on the remaining proceeds are deferred until the investor sells shares, at which point the proceeds are taxed at the capital-gains rate.  The income of the trust must be “qualifying” income, meaning that it must come from

  • interest
  • dividends
  • rent proceeds from real property
  • gains from the sale or other disposition of real property
  • income/gains from commodities or commodities futures or
  • natural resource activities, broadly defined.

Most MLPs generate their income from energy, timber, or real estate.

In addition to the tax benefits, MLPs offer the prospect of generous income payouts when things are going well.  As Brush notes, some MLPs are yielding in excess of 12%.

There are risks, of course:

  • Profits, and therefore distributions, are not guaranteed
  • In resource-based MLPs the resource base eventually runs out unless new assets are acquired
  • Profits are sensitive to commodity price fluctuations (this is a benefit when prices are high)
  • Business growth typically requires leverage since most profits can’t be reinvested in the business
  • Tax treatment of MLPs could become less favorable in the future

As the article notes, the tax paperwork for Master Limited partnerships can be a nightmare; in some instances you might even have to file income tax returns in multiple states.

OK, so why do I have a bone to pick with Michael Brush’s otherwise-excellent article?

Well, he begins by pointing out that returns on cash, CDs, and Treasuries are really skimpy right now.  This is certainly true.  But the article then moves quickly to the assertion that MLPs are “a fairly easy way to make your money earn a double-digit return.”

The problem is that there is no real comparison between the risk level of MLPs vs. Treasuries, or MLPs vs. FDIC-insured CDs.  People invest in traditional income securities because they either need to park cash in liquid form for the short term, or they need to have a certain amount of their invested assets in low-risk securities.  There’s an obvious diversification benefit from this approach.  If an investor has a reason to have, say, 10% of his or her investments in very-low risk securities like Treasuries, that person would not be making an equivalent investment by moving the funds into MLPs.

It’s true that MLPs pay a higher rate of return than cash or CDs, but there’s a reason for that: they are riskier.  Although I agree with Brush’s comments on the attractiveness of MLPs, in no way should anyone think that they are “safe” investments.  They pay a risk premium, just like stocks.  MLPs can go bankrupt, just like corporations.  There is no FDIC-equivalent standing by to repay your money if your master limited partnership fails.

As Brush argues, Master Limited Partnerships appear undervalued right now – but the fact that an investment is undervalued doesn’t mean that its price has to go up in the short-term.  MLPs could go down even more before they turn around.  If you put next year’s college tuition into an MLP in an attempt to get more bang for your buck, it could easily blow up in your face.

Am I saying that you shouldn’t invest in Master Limited Partnerships? Nope.

It might be appropriate to have some of your risk capital – money that you want to invest in risky assets like stocks – in MLPs.  But you should not move money that you have a reason for currently allocating to cash, CDs, or Treasury bills/notes/bonds into MLPs unless you’ve made an independent decision to change the risk profile of your portfolio.  I’m afraid that some of Brush’s readers won’t understand this, but it’s pretty important: if you have $X for which Treasuries or some other semi-guaranteed asset is the appropriate allocation, you should not invest that money in an MLP.

I think I’m reacting to this so strongly because this is the kind of article that I would have read as a young investor years ago and thought, “cool, this sounds much better than the wimpy returns I’m getting on my CDs.” I have no doubt that there will be people who’ll read this article and will move money from cash-type investments to MLPs without understanding that they have made a huge change in their asset allocation.

Disclosure:  I don’t currently own any of the securities described in Brush’s article.

image by: Timmy

About the author

Thomas Fisher, CFP®
Thomas Fisher, CFP®

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