Higher interest rates have a number of implications for investors in master limited partnerships (MLPs).

Record low interest rates over the last decade have created major challenges for income investors, who through 2007 had enjoyed generous yields on risk-free investments such as savings accounts, money market funds, CDs, and U.S. Treasury bonds.

MLPs
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Today, many of those assets offer paltry or even negative interest rates, helping explain why MLPs have become increasingly popular during this time of low interest rates.

These (generally) energy-focused infrastructure stocks are structured in such a way as to pay generous and often growing yields.

Thus they have become a major staple in many investors’ dividend retirement portfolios.

However, thanks to the worst oil crash in over 50 years, many MLPs have been hit by hard times over the past few years. Many of them have dangerously low Dividend Safety Scores.

And with interest rates not just rising but the pace of rate hikes expected to accelerate over the next few years, many MLP investors are worried what this means for the MLPs in their portfolios.

Let’s take a look at why MLPs are so interest rate sensitive, and more importantly how MLP investors should position themselves going forward.

Why Interest Rates are Important to MLP Investors

Like real estate investment trusts (REITs), MLPs are pass-through entities, meaning that they pay no corporate taxes because they payout the majority of their distributable cash flow (DCF – the MLP equivalent of free cash flow) as distributions (i.e. tax-deferred dividends).

However, this has important ramifications for the industry’s business model.

Specifically, because MLPs retain very little cash flow for growth, they need to constantly tap external debt and equity markets (i.e. sell new shares) in order to complete new projects to grow DCF and payouts over time.

This reliance on external capital sources means that MLPs generally carry high amounts of debt on their balance sheets and are frequently selling new units (the MLP equivalent of shares).

Thus, with higher interest rates likely meaning higher debt costs moving forward, most MLPs will see higher costs to fund new projects and refinance existing debt.

And when it comes to unit prices, which are an important factor in an MLP’s ability to grow, here too rising rates represent a significant risk.

That’s because, as interest rates rise, yields on risk-free investments such as money market funds and Treasury bonds will also rise.

As a result, more competition is created for new capital that, up until now, MLPs haven’t had to contend with.

Since the financial crisis, MLPs have been thought of by many investors as bond alternatives, owing to their tollbooth-like business model (i.e. steady cash flows secured by long-term, fixed-fee contracts).

And so, as with bonds, higher interest rates mean that investors are likely to demand higher yields on MLPs going forward. As a result, unit prices could fall (yields rise when prices fall).

However, while higher yields are great for new investors who can lock in an attractive yield on cost, it also means that an MLP trying to raise a certain amount of money to fund its growth will need to sell more units because the price of each unit is lower.

In other words, future equity sales will likely result in more dilution. Accretive growth opportunities, in which the increase in DCF outweighs the increase in unit count (increasing DCF per unit and allowing sustainable payout growth), will be harder to come by.

This is especially true because most midstream (e.g. energy transportation, processing, and storage) MLPs have a general partner who serves as sponsor and manager of its assets.

General partner’s own not just a large portion of the limited units (i.e. what investors buy), but also incentive distribution rights (IDRs).

IDRs are highly profitable for the general partner because they grant it the right to up to 50% of marginal DCF above a certain distribution level.

While this creates an incentive for the sponsor to grow the MLP’s distribution quickly, it also raises the MLP’s cost of capital because only half of any new projects’ cash flow ends up going to investors.

In fact, because of IDRs, MLPs are more interest rate sensitive than REITs, which also rely on external debt and equity capital and are thus very rate sensitive as well.

MLPs are more sensitive to higher interest rates because of one other important factor that REITs don’t have to deal with – commodity prices, specifically oil and gas.

Since oil and gas are priced in U.S. dollars, a strengthening dollar can cause the price of oil and gas to decline.

Why would higher interest rates cause the dollar to increase?

Sluggish economic growth in other economies, such as the U.K., the E.U., and Japan, has caused the central banks there to keep interest rates very low or even negative.

Higher interest rates in the U.S. attract foreign capital because people from around the world are eager to invest in higher rate U.S. assets such as risk-free Treasuries.

That in turn requires converting their foreign currency to dollars and raised demand for the greenback. In addition to the supply headwinds hurting the price of oil and gas, the stronger dollar could also keep a lid on prices, which are still trading at about half of their pre-oil crash levels.

Low energy prices have decimated the balance sheets of oil companies, resulting in massive cuts to capital spending, lower production, and decreased demand for midstream services.

While the majority of most MLP’s DCF is from long-term contracts, not all of these contracts have minimum volume provisions, meaning that many MLPs have far more commodity exposure than investors realize.

This is the reason, for example, why pipeline giant Kinder Morgan (KMI) was forced to slash its dividend by 75% back in 2015, after its acquisitions of its MLPs left it with an unsustainable debt load and its low share price created a self-perpetuating liquidity trap (i.e. unable to sell shares at high enough levels to raise new capital).

Some MLP customers are no longer financially healthy enough to honor the long-term contracts they initially signed as well, creating additional risk.

Since many MLPs, such as Energy Transfer Partners (ETP), took on massive amounts of debt back when oil was over $100 per barrel, higher debt service costs, as well as a lack of access to cheap equity capital (due to low unit prices), have forced many highly leveraged MLPs to cut their distributions over the past few years.

Higher Interests Rates are Not a Reason to Avoid Quality MLPs

While many MLPs are facing a potential perfect storm in the form of low energy prices (that may persist for several more years) and rising interest rates, which will mean higher debt and equity costs, that doesn’t mean that investors can’t still earn reasonable returns from parts of this beaten down sector.

However, it does mean that you need to be very selective in terms of what MLPs you buy. After all, there are a number of key MLP risks that have kept me from investing in the sector.

Blue chip midstream MLPs such as Enterprise Products Partners (EPD) and Magellan Midstream Partners (MMP) have long and proven track records of being able to grow steadily in various economic and interest rate

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