Looking for an attractive alternative to traditional fixed income securities? For income-focused investors, exchange traded pass-through securities have long been an area of fascination. After all, they distribute nearly all of their profits back to shareholders...
Looking for an attractive alternative to traditional fixed income securities? For income-focused investors, exchange traded pass-through securities have long been an area of fascination. After all, they distribute nearly all of their profits back to shareholders thereby creating an attractive revenue stream with the potential for strong yield generation in a variety of market environments. At LoCorr, our Spectrum Income Strategy focuses on six primary sectors: CEFs, PTPs, MLPs, BDCs, REITs and Preferred Securities. The potential combination of higher yields and low correlations to traditional fixed income has made these securities an attractive diversifier to bonds. Currently, the team is focused on mid-stream MLPs and in particular, pipeline and energy infrastructure MLPs. While we own MLPs in other sectors as well which we like for different reasons, we believe now is an excellent opportunity for the pipeline sector based on strong and improving fundamentals and very attractive valuations.
The ride for MLP investors has been volatile to say the least. The last major price move for MLPs peaked in 2014 on enthusiasm for the development of US shale and the need to transport larger volumes out of the shale basin and into major markets. Liquidity flows into the sector were bolstered by the availability of sector ETFs which facilitated participation by short-term oriented funds in addition to the traditional shareholder base of income-oriented, buy and hold investors. As we can see in the chart below, AUM in the Energy LP category, as defined by Morningstar, peaked at just under $50 bn.
*Data Source: Morningstar, Inc.; data as of 12/31/17
Excessive oil production prompted a decline in oil prices, which in turn led to a major decline in the sector as investors, particularly those short-term oriented ones, withdrew. The sector, as measured by major indexes, bottomed in the beginning of 2016, along with the price of oil. From a fundamental perspective, the pipelines themselves had been overbuilt on a short-term basis and consolidation was certainly in order, although the long-term growth potential of the US shale industry was still strong. It is worth noting that the fundamentals of the pipelines are not materially affected by the price of crude; they tend to trade with the commodity over the short-term despite the fact that their revenues and distributions are tied primarily to volume which is tied to economic growth. For long-term institutional investors, this presented some very attractive opportunities.
*Data Source: Morningstar, Inc.; base = 100; data as of 1/31/18
Through 2016 and early 2017, the sector recovered partially from the earlier losses as oil prices improved, and it was during this early period that we increased our exposure. The outlook for the sector was still somewhat murky in the short-term due to uncertainty about Organization of Petroleum Exporting Countries (“OPEC”) production and little apparent consolidation in the industry; many of these firms, despite being fairly significant in terms of market cap, were young enough to still be headed by charismatic founders who were reluctant to surrender their positions in mergers or acquisitions. Operations of the sector as a whole continued to be strong, though there were some distribution cuts primarily among companies which had taken on excessive leverage.
The sector finished 2017 on a weak note. This was due in part to the modest decline in oil prices but also due to the competition from technology stocks which outperformed so much that the energy sector in general was of little interest to mainstream equity managers. Despite all of this, distributions remained stable amongst the firms we held which provided us with greater confidence as we moved into the new year.
During 2018, we are very optimistic about pipeline MLPs for the following reasons:
For fixed income investors who are looking for an income-focused strategy that offers a diversified return stream, we believe pass-through securities offer an attractive alternative to traditional bonds. Trust and Fiduciary Income Partners (“TFIP”) is a sub-advisor to the LoCorr Spectrum Income Fund. TFIP allocates amongst six primary sectors based on the most attractive risk-based return. At the moment, they see tremendous opportunity in pipeline MLPs.
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Correlation is a statistical measure of the degree to which the movements of two variables (stock/option/convertible prices or returns) are related.
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