Low interest rates have many investors scrambling to find ways to increase the yield on their portfolio. Most experienced investors know that increasing yield also means increasing risk. Unfortunately many people seem to think there is a free lunch in the investment world that can provide them with a higher yield without risk. The huge cash flow into bond funds is just one example. Bond funds cannot guarantee principal and bond prices go down when interest rates rise. It’s only a matter of time until interest rates will start going back up and bond fund owners will be in for a rude awakening.
Another way investors have been improving yield is by buying master limited partnerships (MLPs). An MLP is a publicly traded security that combines the tax benefits of a limited partnership with the liquidity of the stock market. They are limited to engaging only in certain types of businesses, mainly natural resources. The objective of the MLP is to avoid double taxation that potentially applies to corporations. Corporations pay income taxes on their earnings. Some of the earnings are then distributed in the form of dividends to their shareholders who then pay income taxes again on the same earnings. MLPs avoid paying tax at the corporate level. To qualify, the MLP must generate at least 90 percent of its income from what the Internal Revenue Service deems “qualifying” sources and then distribute most of the income to shareholders.
The requirement to distribute most of their income makes the yield on MLPs very attractive. A list of the top 25 MLPs published by The Yield Hunter recently reported an average yield of 7.03%. That is extremely attractive in the current interest rate environment.
Yields this high do not come without risk. The biggest risk lies in the tax nature of MLPs – they are involved in natural resources, essentially commodities. Commodity prices are volatile and therefore the dividend yields can and do change, sometimes significantly. Many MLPs derive their income from timber and natural gas production. These are depleting resources. Some of their dividends are considered a return of principal because the forest is being harvested or the gas well is eventually going to run dry. Investors need to be aware that some of the yield is actually their original investment being paid back slowly.
One way that MLP investors attempt to minimize their risk is to buy them through an exchange traded fund (ETF). The ETF spreads out the risk by owning many MLPs with one purchase. Unfortunately, pure MLP ETFs have a big downside. ETFs are regulated investment companies which are allowed to pass through earnings to shareholders avoiding the double taxation of corporations. Regulated investment companies may not invest more than 25% of the portfolio in MLPs. If they do they are they are considered corporations and subject to tax. Pure MLP ETFs pay income tax on the dividends earned from their holdings (up to 35% tax) and then pass the residual along to shareholders who then must pay tax on the income received. The objective of setting the company up as an MLP has been negated by the ETF structure.
A 7% yield on an MLP may sound good but it is filled with risk that cannot be diversified. You can invest in more than one MLP or invest in multiple MLPs through an ETF (although the yield will be reduced by taxes within the ETF). However, all MLPs are narrowly invested in the natural resources providing little diversification.
Even if the principal holds and the dividend is maintained, you can’t spend the entire amount if you want to fight inflation.
The proper way to generate income from a portfolio is to invest for total return and use the 4% prudent withdraw rule to take out spendable income. The portfolio should be broadly diversified to minimize risk and then properly allocated between stocks and bonds to take advantage of volatility. Disciplining yourself to stick with this strategy avoids the temptation to chase yield and inadvertently increasing your risk.
- MLPs avoid double taxation by distributing most of their income and deriving their return from qualifying sources like natural resources.
- Pure MLP ETFs do not avoid double taxation and may pay internal tax rates as high as 35%.
- The proper way to generate income from a portfolio is to invest for total return and use the 4% prudent withdraw rule to take out spendable income.