Investors debate risks versus opportunities in investing in beaten-down MLP ETNs

By Emma Trincal

New York, Jan. 16 – With exchange-traded notes linked to master limited partnerships suffering hefty losses as an oil-related investment, advisers are considering whether holding on to these high-yielding instruments is worth the risk of losing more capital or if, on the contrary, buying them may be a timely opportunity.

MLPs offer tax benefits, such as tax deferrals and tax deductions, that are characteristic of limited partnerships coupled with the liquidity of a stock.

ETNs linked to MLP indexes lack some of the tax benefits but spare their investors the burdensome filing of K1s at tax time.

The ETNs provide diversification as they are linked to MLP indexes. But investors are subject to credit risk, advisers said.

Yield machines

MLPs and MLP ETNs are particularly attractive to income investors seeking higher yields in a low interest rates environment, said Michael Kalscheur, financial adviser at Castle Wealth Advisors.

For instance, Barclays Bank plc’s iPath S&P MLP ETN has a 6.3% yield. The yield on the largest MLP ETN, JPMorgan Chase & Co.’s ETN linked to the Alerian MLP index, is 5.4%. Citigroup, Inc.’s C-Tracks ETN linked to the Miller/Howard MLP Fundamental index has an indicative yield of 4.8%.

At the same time, most of those ETNs have registered losses in a range of 4.5% to 6.5% so far this year, compared with the 1.95% decline in the S&P 500 index. Oil has fallen by 7.5% since the beginning of the year.

“There’s a lot of volatility in the markets right now in all asset classes – equities, rates, commodities – and MLPs and FX have been especially hit,” said Keith Styrcula, chairman of the Structured Products Association.

“From an SPA perspective, I’m aware of a few QIBs that have expressed interest in structures linked to MLPs, but the volatility is likely to continue. Not an investment vehicle at this time for conservative accounts.”

The acronym “QIBs” refers to qualified institutional buyers.

“MLPs got creamed. We own two of them with yields of over 8%. If you can get an investment that can pay 8% and doesn’t have to do anything, it looks like a pretty conservative bet,” said Kalscheur.

Long-term value

Kalscheur said he has not invested in a structured note tied to the MLP asset class yet, but he would consider it.

“The inherent nature of a structured note is to take a long-term bet, say five year[s]. What would oil be in five years? Will it be up from now? Will I take a five-year bet on oil at this point? You’d better believe it,” he said.

“I really like holding individual names, but with MLPs there are too many tax considerations to take into account. I don’t want to take the time to research those names, so you can take $10,000 in the JPM Alerian ETN; that’s a good way to do it.

“One of the nice things about ETNs is that you get to invest in a particular industry or sector. It’s indexing on a particular sector or asset class. You can do sector rotation around the S&P.”

The price of the JPMorgan ETN tied to the Alerian index has dropped 5.4% in the past two weeks.

“It’s been beaten up so much, I would say, why not take advantage of it?

“I think that buying the JPMorgan Alerian ETN right now is not a bad idea. Sure, it’s in the headlines, but you make money when there is fear and blood on the Street. If you look at the past three-month chart, the ETN had a low of $40.73 in December and a high of $53.34 in November. We now are at $43.90. That puts us above the low by 8%. Without doing some technical analysis, it looks like the market has been spooked a few weeks ago but that things may start to get a little bit better.

“I would consider this ETN. I like those instruments in general. You have to be careful about taxes though. But I think MLP ETNs may offer great value at this point for the long-term investor.”

No K1 hassle

Most MLPs are oil and gas pipelines. As such they have large tax depreciation and depletion deductions, explained a tax lawyer.

Income distributions from MLPs are deferred to the time of sale and are treated as capital gains.

Such advantages are not available to MLP ETN investors, who do not directly own the shares. As a result, distributions get treated as ordinary income. But MLP ETN buyers have the benefit of filing a 1099 for taxes, circumventing the burdensome K1 filing, which “most people don’t like to deal with,” the lawyer said.

The tax-filing process is not an essential consideration for Juin Chin, senior investment analyst at Modera Wealth Management, LLC.

“Our large clients already have K1s, they do K1s. Escaping the tax burden of K1 filing is not a great motivation for them,” he said.

“The ETN is an easier vehicle, but distributions are taxed.

“Also, when you buy an MLP ETN, you have counterparty risk.”

Caution

But MLPs as a contrarian investment made sense to him.

“We’ve been looking at MLPs sporadically. This asset class as a whole is definitely taking a hit,” he said.

“If we were to do MLPs, the ideal structure for us would probably not be ETNs. We would rather buy MLPs directly.

“We may use separate managed accounts managed by asset managers who specialize in MLPs and pick the names for us. But that’s only for clients who want the exposure at this time.

“We like the tax benefits of directly investing in MLPs. The client actually owns the stock. When there is income distribution, it actually reduces the cost basis of what the client bought. Even though you have to file the K1, it’s a very interesting investment from a tax standpoint. With an ETN, investors get the distributions taxed at the individual income rate. It’s not as appealing in that way.”

Overall, Chin remained cautious.

“Both MLPs and MLP ETNs have shown similar performances. Both have been beaten down,” he said.

“I wouldn’t buy the asset class right now. Valuations are attractive, but MLPs might fall even more.

“It’s really a function of your outlook on energy prices, how much you see them falling from here. We’d rather err on the side of caution and wait.”

Near bottom

Clemens Kownatzki, independent currency and options trader, said MLPs are attractive right now from a value standpoint.

“I was just discussing this with another trader: oil is a valid contrarian play right now. I guess you can definitely use MLPs and MLP ETNs as part of a value or contrarian strategy. Oil prices have dropped so much, in my opinion, the downside risk is limited,” he said.

Oil is trading right now between $45.00 and $48.00 a barrel. The commodity has seen its price drop 55% since its high in September.

“Nobody is going to drill oil at $20. The cost of getting oil out of the ground is so high ... it can’t fall that much more without creating a new supply and demand equilibrium. At some point, some companies will stop drilling, others may go out of business, and the excess supply will simply adjust. Meanwhile, we still need oil. Oil is not going away for the next 30 to 40 years. That’s why I think we’re very close to the bottom.”

Investing in an MLP ETN for the capital appreciation let alone the yield was not a bad move, he said.

“ETNs tied to an MLP index have their own risks, and you have to carefully look at the underlying. But the diversification across several MLPs spreads the risk, so that’s a good thing,” he said.

As an equity and option trader, however, Kownatzki said that MLP ETNs would not represent his instrument of choice.

“If I wanted to be a contrarian with MLPs, I would probably use an ETF instead. I would also do oil futures or options on oil stocks. Another idea is to short some of the airlines stocks. There are many ways to play the oil recovery theme,” he said.

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