An Easy and Effective Way to Buy MLPs

12/05/2011 9:00 am EST

Focus: ETFs

Josh Peters

Editor, Morningstar DividendInvestor

Master limited partnerships can be attractive high-yield securities, but because of their tax characteristics, they are more complicated to own than ordinary stocks. Here’s a way to get the income from MLPs without the paperwork, explains Josh Peters of Morningstar DividendInvestor.

Since the Internal Revenue Service does not allow the taxable income that MLPs allocate to individual partners to qualify for tax deferral, MLPs should not be owned in tax-deferred accounts such as IRAs, Roth IRAs, 401(k)s, and such.

Noticing the sector’s appeal for income-seekers, Wall Street has developed a number of investment vehicles in recent years to give investors access to MLPs without the associated tax problems. Trouble is, most of these vehicles (traditional open-end mutual funds, closed-end funds, and exchange traded funds) solve the tax issue by becoming taxpaying entities, which over the long run will drag on shareholder returns.

For tax-sensitive exposure to the MLP sector, a different structure—the exchange traded note—may be the optimal solution. An ETN is similar to an exchange traded fund in that it trades on an exchange, tracks the returns of a specific index, and its units are continually created and redeemed based on market demand. That is where the similarities largely end.

An ETN is actually a bond whose principal value fluctuates with the price of the underlying index and whose interest payments are a function of the income being paid by index constituents (less fees, of course). The issuing banks take investors’ money and invest in the underlying components or employ other hedging strategies to collect returns that match the index.

Fees aside, the principal drawback of an ETN is that it represents an unsecured obligation of the bank behind it. The investor isn’t just taking the risks associated with MLPs, but also the credit risk of the issuer.

In choosing from the handful of MLP sector vETNs that are now available, this credit-risk issue looms large. This is the principal reason the ETN issued by JPMorgan Chase (JPM), arguably the strongest of the biggest US banks, gets the DividendInvestor nod of approval. Other ETN issuers include UBS (UBS), Credit Suisse (CS), and Morgan Stanely (MS).

In addition to our view that it has the best financial backing, the JPMorgan Alerian MLP Index ETN (AMJ) is also the largest and most liquid of the group, with $2.9 billion in assets as of mid-October. The underlying index cuts a broad swath across the sector. To date, quarterly distributions have fluctuated somewhat because of index rebalancing requirements.

In general, though, its payout should track the distribution growth of its holdings. Based on the 48.45 cents per unit distribution paid September 6, AMJ currently yields 5.5%. With distribution growth across the sector running in the low- to mid-single digits, AMJ (like its sector) looks just a bit expensive, but still capable of delivering a decent total return.

Depending on the investor’s circumstances, owning AMJ instead of individual MLPs may offer several advantages. While there is a fee—0.85% of assets per year (all providers currently clip the same charge)—there will be no drag from the unnecessary layer of taxation involved in other MLP sector products.

AMJ’s distributions are characterized as interest for tax purposes, and therefore taxable as ordinary income. Unlike owning MLPs directly, there’s no opportunity to defer taxes thanks to high upfront depreciation charges. However, in a tax-deferred account, neither the tax rate nor the deferral matters, since the income isn’t taxed when received anyway.

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