Investment Solutions

Federal Reserve Action Supportive for MLP Investments

September 19, 2012

Recent Event: Last week, the Federal Reserve (Fed) decided to continue its quantitative easing (QE3), announcing plans to extend its Maturity Extension Program through December 31, 2012. The program calls for the purchase of $40 billion in mortgage backed securities each month until there are signs of significant improvement in the labor market. The Fed also provided guidance for the period during which it expects to maintain exceptionally low fed funds rates through at least 2015.

Background: In historic context, an MLP is an entity that is structured as a limited partnership instead of as a C corporation (C corp.). Limited partnership interests (limited partner units) are traded on public exchanges (i.e., NYSE, NASDAQ, and AMEX) just like corporate stock. Most MLPs were created primarily to hold assets that have tremendous amounts of cash flow, such as pipelines. In a model similar to Real Estate Investment Trusts, MLPs must distribute all of their cash flow to investors and are not taxed at a corporate level. There are many positive attributes that this asset class has to offer, including:

Framework for Investment: We believe the recent Fed announcement is positive forMaster Limited Partnerships (MLPs). The current yield on Alerian MLP Index is ~6.50%, placing them at a compelling spread between other yield orientated investment vehicles:

10 Year Treasury 1.79%
5 year Treasury 0.68%
Moody's AAA Corporate Bond Index 3.67%
MSCI Real Estate Investment Trust Index 3.30%

Important to note, is that most MLPs which have outperformed the S&P 500 index over the past 10 years are growing their distributions (dividends) ~5%-7% annually. Historically, MLPs have been able to grow their distributions faster than interest rates have risen, offering an effective hedge against inflation. Rather than taxable investment income, the distributions are treated as a return of capital and reduce the partner's cost basis in his/her partnership units. The asset class also offers a tax efficient means of transferring wealth (When an individual who owns an MLP passes away, the individual’s MLP investments can be transferred to an heir. When doing so, the cost basis of the MLP is reset to the price of the unit on the date of transfer. Thus, the tax liability created by the reduction of the original unit holders cost basis is eliminated.) We firmly believe investors should have exposure to these high quality companies with strong balance sheets, stable business models, and consistent growing distributions (dividends) making them the single best asset class in the current market environment, in our opinion.

Outlook: Longer term, the rapid growth in oil and gas production from the unconventional shale plays has created significant demand for new midstream projects. This new midstream infrastructure development should, in our view, sustain ah highly profitable secular growth story over next several years (Interstate Natural Gas Association of America INGAA projects $250+ billion capital investment in midstream infrastructure over the next 25 years). MLPs are the natural beneficiary of this development.

Paul Elliot, CFA     Dan Tulis, CFA     James Elliot, CFA
Will Maze    Paul Doran

 

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About ELCO Management, LLC
Established in 1995 and based in New York, ELCO Management (www.elcomanagement.com) offers investment solutions to high net worth individuals and institutions. ELCO also manages two highly specialized energy funds: the ELCO Energy Fund, L.P. and the ELCO Select Fund L.P.