5 MLPs to buy at a 10% discount

Dividend Investing, IPO, Master Limited Partnerships (MLPs)

A visit to acronym city will let us walk out with a handful of investment choices that offer attractive, tax-advantaged yields couple with strong prospects for growth. To more quickly get to the money-making good stuff let’s start with a few definitions:

  • Master limited partnership (MLP): A business structure where investors own limited partnership units that trade on the stock exchanges. The option to organize as an MLP is limited to companies involved with energy or natural resources production, transportation, and/or processing.
  • Closed-end Fund (CEF): An investment fund that issues a fixed-number of shares through an initial public offering (IPO) and after that neither sells or redeems shares. CEF shares trade on the stocks exchanges, with prices set by market supply and demand forces.
  • Net asset value (NAV): The value of a CEF share calculated by dividing the current value of the fund’s assets by the number of shares outstanding. The market price of a CEF share may be higher or lower than the calculated NAV.

As a group, MLPs pay very attractive distribution yields with most of these companies striving – and accomplishing – to increase the distributions paid to investors every year. As a result MLP investors earn steady and growing cash income streams usually accompanied by share price increases. The problem with investing in MLPs is the complicated tax reporting. An MLP sends out a Schedule K-1 listing the investor’s proportional share of profits, losses and deductions. Adding K-1 reporting to your tax return increases the work required and cost if you use an accountant. An investor may also need to file numerous state income tax returns and a K-1 reporting investment held in an IRA can lead to additional tax liabilities.

Packaged investment products like mutual, exchange-traded and closed-end funds face tax issues similar to an individual investor. A fund that has more than 25% invested in MLPs loses its pass-through income tax umbrella. A fund that wants to focus on MLPs must file and pay taxes as a corporation, resulting a lower return to investors. As a result, an MLP ETF will not keep up with the index it tracks, and the larger ETFs covering MLPs have under-performed by 30% to 35% per year. The lower results make sense considering the maximum corporate tax bracket is 35%.

CEFs have some advantages that allow this type of fund to invest in MLPs and provide attractive returns to investors. Fund rules allow a CEF to use up to 25% leverage to boost returns. In the case of an MLP CEF, holding investments worth 1.33 times the fund’s equity provides extra returns to offset the tax bite. As an investor you can also search out those CEFs with share prices trading at a discount to the NAV, allowing you to buy a dollar worth of MLP assets for less than a buck. The combination of leverage and price to NAV discounts puts the MLP focused CEFs well above other fund types in investment performance.

A screen of closed-end funds produces five funds with price to NAV discounts greater than 10%:

  • Tortoise Pipeline and Energy Fund (NYSE: TTP) Current yield: 5.54%. Discount to NAV: 13%.
  • Tortoise Power and Energy Infrastructure Fund (NYSE:TPZ) Current yield: 5.86%. Discount to NAV: 12%. TPZ pays monthly dividends.
  • ClearBridge American Energy MLP Fund (NYSE: CBA) Current yield: 7.26%. Discount to NAV: 10.75%. This fund IPO’d in June 2013.
  • Neuberger Berman MLP Income Fund Inc (NYSEMKT: NML) Current yield: 6.88%. Discount to NAV: 10.4%. Fund IPO’d in April 2013. NML pays monthly dividends.
  • Cohen & Steers MLP Income and Energy Opportunity Fund (NYSE: MIE) Current yield: 6.89%. Discount to NAV: 10.1%. MIE launched with an April 2013 IPO.

Note that four out of five funds are a year or less old. As these funds develop a track record, the discount to NAV should narrow, increasing your total return if you invest at the current discount levels.

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