Should Anyone Buy MLPs Yielding 19%?

Yesterday the WSJ had an article about recent MLP IPOs that offer higher yields from non-traditional partnership assets. I had a similar post a couple of weeks ago but the Journal piece includes mention of a partnership that pays off of sand used for fracking and another one based on gas station revenues.

These alternative MLPs are being portrayed as being riskier than some of the more mundane MLPs and while I don't know for a certainty that they are riskier, the significantly higher yields are a good indication that they are. Working on the assumption these new alternative MLPs are riskier it is a repeat of past market behaviors. The IPOs are being created to meet investor demand for higher yield. The arc of this is that as the theme/mania/whatever you want to call it matures, the quality of the IPOs get progressively worse. I do not know what inning we are in with this, it could be very early days but the pattern is one that recurs.

Hopefully it is clear that MLPs yielding 4-6% will generically have less risk than those yielding 8-9%. Northern Tier (NTI), the gas station MLP, was priced at its IPO to yield 19% and now that it is up a lot the yield at the current price is expected to be 12%. It looks like it has not actually paid out yet and I have no idea what the actual payment will be. The article cites a couple of these that have done well so far and one that has done poorly.

MLPs have been doing very well for a while now along with many yield oriented equities which creates a sense of comfort which creates a willingness to take a little more risk until something bad happens. Again this is a pattern that repeats often but does not have to happen every time. It is worth understanding the behavior and the pattern, though.

If you read enough you will find suggested allocations to MLPs as high as 20-25% of a portfolio. I think that kind of weighting is very aggressive. Every so often odd things happen in narrow segments. In October 2006 you may recall that the Canadian government announced changes in the way the Canadian royalty trusts would be taxed which caused a meltdown in the group. The hindsight brigade might say that they would just hold on in the face of an outlying event but based on the price action people were clearly selling in a panicked fashion into the news.

Anyone wanting to build a portfolio that yields 4-6% can probably do so without having to put 20-25% in one segment/product. I want to be clear that a portfolio that yields 6% is not going to be well diversified in my opinion. If your reading 4-6% and thinking "more like 8-10%" then I hope you realize the risk you are taking and if you don't think you're taking a lot of risk then I hope you don't learn the hard way.

MLPs have a place in a diversified portfolio and also yield-centric portfolios. Allocations smaller than 20-25%, like maybe 5-10% each could go to MLPs and REITs, there are obviously sectors known for yield that could be modestly overweighted without putting 25% into one of these sectors, there are a coupe of high yielding low volatility country funds out there along with some high yielders in sectors that may not be thought of for their yield. Most people are probably aware that dividends in the tech sector have been going up a lot in the last few years. There are also plenty of foreign stocks with hefty yields.

So anyone wanting a lot of yield can find it without putting 25% into one niche. One risk factor that does not come up enough in related articles is the extent to which going all out for yield exposes the portfolio to interest rate risk. Rates are very low and the Fed is committed to do all they can to keep them low but if rates go up then a portfolio with a very high yield is vulnerable to a big drop. Some might say that as long as the dividends keep flowing and growing they will be fine and maybe that is so but this line of thinking reminds me of the quote related to boxing about everyone having  plan until they get hit in the mouth.