There’s No Free Lunch – Reaching for Yield in MLPs

Investors have been looking for income from alternatives to low yielding bonds since the Federal Reserve lowered the interest rates to zero after the 2008 financial crisis.  This search for income in a low interest rate environment has led to a huge inflow of investment into master limited partnerships and high yield bonds over the last few years.  According to the Wall Street Journal, from 2010 to 2014 a net $44 billion flowed into MLP mutual funds and exchange-traded funds.  Lured by yields of 6% plus at a time where the 10 year treasury bond yields 2 percent, investors have been forced into assets that carry far more risk.

As the US oil shale business boomed MLPs became attractive vehicles for investors looking for higher return.  If we go back to the fundamental tenant of economics that there’s no such thing as a free lunch, we would expect that the higher returns from MLPs would carry a higher level of risk, yet investors have treated these investment vehicles as sure things up until now.

The Alerian MLP Index has fallen 40% this year as the drop in the price of oil has worried investors that the high payouts generated by the oil transport companies that make up most of the MLPs are not sustainable.  Investors were blinded to the risk of these investments by the desire to earn an above market yield, but the yield reflected the risk that this type of loss of principal was possible.

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