The Three Best Low-Risk, High-Yield MLPs

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Master Limited Partnerships (MLPs) are the energy companies of choice for investors looking for steady income without too much risk. Three energy MLPs in particular look very good, with strong track records, great future prospects, and yields above 5%.

And because of a unique tax loophole, investors who hold MLPs for the long term can completely avoid paying taxes on 80 to 90% of all of their earnings.

For MLP investors, those returns can be substantial. In fact, several of the 50 companies in the benchmark Alerian MLP Index offer yields of 7.5% or higher, and the index’s current yield is 7.4%. That doesn’t include the gains in the underlying shares.

When including these yields and dividends, the Alerian MLP index has outperformed the S&P 500 in 12 of the last 15 years. In fact, in the 14 years since starting in 2000, the Alerian MLP index averaged an annual total return of 21.3%, while the S&P 500 averaged only 6.1%.

And that’s not including the tax savings you would get from investing in MLPs rather than regular shares…

What is a Master Limited Partnership?

For the most part, MLPs are involved in the business of connecting energy-producing fields with refineries, distribution, and retail sales centers.

In practice, that typically means companies engaged in the extraction, storage, and transportation of energy commodities, such as oil, natural gas, and coal, although MLPs do crop up in other industries, such as shipping.

But, despite popular belief, most have limited exposure to commodity prices.

That’s because most MLPs own midstream energy assets such as feeder pipelines and storage and transport facilities.

It’s a great business model because MLPs don’t actually take ownership of the commodities. They transport, store, and process them.

Doing so, they simply act as gate-keepers, extracting a heavy toll every time a transaction takes place. So when oil or gas is moved from Point A to Point B, MLP pipeline owners get paid.

And when U.S. LNG exports take off in 2016, MLPs that own the pipelines, processing facilities, and shipping necessary for LNG exports will take a cut.

Or when oil has to be stored, as producers attempt to wait out the slump in oil prices, MLPs that own the storage facilities get their cut. So when U.S. crude storage levels reached their highest level in 80 years in April, that was good news for MLP investors. And those levels have only gone down 7% since, despite the end of the summer driving season.

In fact, almost anytime anything happens in the energy sector, MLPs investors get paid, whether the price of oil, natural gas, coal or other commodities goes up or down.

It all adds up to healthy and stable profits that, by law, are passed on to investors. Their position as intermediaries makes MLPs a safe and stable source of income, especially in volatile times.

How Master Limited Partnerships Beat the Tax ManUnlike ordinary stocks, MLPs offer a significant tax shield for investors.

You see, like real estate investment trusts, MLPs are pass-through entities that transfer profits and losses to individual unit holders.

But, because of depreciation allowances, 80 to 90% of the distribution you receive is considered a return of capital by the IRS. So you don’t pay taxes immediately on that portion of the distribution.

In other words, 80 to 90% of the distribution you receive is tax-deferred. The remaining 10 to 20% is taxed as regular income.

But here’s the real kicker.

You’re not taxed on the return of capital until you sell the units. What’s more, those payments are used to reduce your cost basis on the MLP.

Let’s suppose you purchase an MLP for $50 and receive $5 in distribution payments, $4.50 of which is considered a return of capital. You pay no income tax on that $4.50.

In this case, only the remaining 50 cents is taxed as regular income. Meanwhile, after one year, your cost basis drops to $45.50 ($50 minus $4.50).

Assuming the distribution remains the same the next year, your cost basis would drop again to $41.00. And so on… and so on.

Eventually, your cost basis could go to zero, leaving you with zero tax liability on 80 to 90% of your returns.

And if you decide to sell the units sooner, the capital gains are taxed at the more favorable long-term capital gains tax rate – a tremendous benefit, especially for older investors.

These savings can end up being worth a lot. Be sure to consult a knowledgeable tax professional when investing in MLPs, to make sure that you maximize this benefit and your returns.

Investing in MLPs Now: Three High-Yield Picks

For those seeking the highest yields with the lowest risk, we’ve identified three MLPs with dividend yields that pay more than 5% and that have strong track records and great future prospects. These are the undervalued gems in the energy MLP sector, as well as being well-poised to increase in value as the energy sector recovers:

  • Genesis Energy LP (NYSE:GEL) – Current Yield: 5.85%. Genesis is one of the most diversified midstream players, meaning it has multiple income streams. The company has about 1,000 miles of pipelines across five states, mostly in the Gulf of Mexico, a fleet of more than 270 trucks and trailers, 50 barges, more than 80 railcars, and a number of terminals and other tank locations. To top it off, the company recently acquired the M/T American Phoenix from Mid Ocean Tanker Company, a 330,000-barrel Jones Act tanker whose services are already chartered into 2020. Distributions have increased for 39 consecutive quarters, making this a reliable and proven income machine, and with facilities in the Gulf of Mexico, Genesis is well poised to see increased revenue once U.S. LNG exports from that area begin in 2015.
  • Enbridge Energy Partners LP (NYSE:EEP) – Current Yield: 8.65%. Enbridge is in the process of shifting some of its most lucrative pipeline assets from its Canadian management company, Enbridge Energy Management, to its U.S. MLP, which should make for even higher yields in the future. Thanks to its operations in western Canada and the North Dakota Bakken formation, the company is the largest pipeline transporter of oil production from those two regions, accounting for approximately 17% of total U.S. oil imports. Its natural gas business is equally strong, delivering approximately 2.2 billion cubic feet of natural gas daily in the U.S. mid-continent and Gulf Coast regions. Its high-yield dividends have increased every year since 2006, making it a strong candidate for ongoing income and long-term appreciation.
  • Crestwood Midstream Partners LP (NYSE:CMLP) – Current Yield: 25.87%. Crestwood Midstream Partners operates natural gas pipelines and processing and storage facilities in premier shale plays across the U.S., including the Marcellus Shale, Bakken Shale, Eagle Ford Shale, Permian Basin, Powder River Basin Niobrara Shale, Utica Shale, Barnett Shale, Fayetteville Shale, and Haynesville Shale. Dividend payments have risen steadily since 2011, and its net income of $21.7 million for the first quarter of 2015 is the highest in the company’s history, representing a 34% increase over the first quarter of 2014. With facilities in the best shale plays in the country and its very high yield, Crestwood is a solid, high-income choice.

Part of what makes MLPs such attractive investments are the tax savings and tax deferrals (see sidebar) as well as the fact that MLPs are legally required to pass their profits on to investors. Most alternative investment vehicles lack these benefits.

But if you’re uncomfortable investing directly in MLPs, there are alternatives like exchange-traded funds (ETFs). The two most popular MLP ETFs available are Alerian MLP ETF (NYSE:AMLP) and JPMorgan Alerian MLP Index ETN (NYSE:AMJ). However, both pass their profits through to investors as ordinary dividends, depriving you of the big tax advantages of MLPs.

Whichever way you choose to invest, MLPs will be a steady source of income for years to come, with the potential for huge tax savings along the way.

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