With the Federal Reserve’s rumored interest rates hikes, many investors are wondering how MLPs will be affected. Historically, MLPs have outperformed other high-yield assets during rising rate environments. This is due to the fact that rates go up in strong economies, and these economies consume more energy, which is beneficial for MLPs.
MLP performance in rising rate environments
With the market concerned about the Fed’s move toward interest rate increases, investors are seeking higher fixed income yields. This is where MLPs can become a valuable portfolio asset because they have performed well in both rising and dropping rate environments, only falling under extreme rates changes. In fact, unlike other high yield assets, MLPs can offset rising rates by growing distributions. According to Mark Litzerman, co-head of Real Asset Strategy at Wells Fargo, MLPs have beaten REITs, utilities and other fixed-income products as interest rates have risen.
“We continue to favor large, diversified, fee-based midstream MLPs with limited commodity exposure,” Litzerman explained. “The reliable distributions of these investment-grade partnerships are expected to continue to grow, even at current energy prices. Meanwhile, we remain cautious about MLPs with more significant commodity exposure, particularly those in the upstream segment.”
While MLP distributions may have more rapid dividend growth than other income investments in low-rate environments, there is still comparative value in higher rate environments. High yield investments like MLPs will become relatively more valuable with rate hikes because of increases in oil and gas production at a time of higher consumption. So although there is no guarantee that MLPs outperform other fixed-income products, that does not mean poor returns.
Rates hikes may increase the cost of capital for MLPs and reduce their distributions, but not to the same extent that other high yield assets have been hit in the past. In fact, throughout the bond sell-off in 2013, MLP prices temporarily dropped but quickly recovered to post strong returns for both 2013 and 2014.
What MLP investors need to consider
Investors should be less concerned about MLP performance in a gradually increasing rate environment, and more focused on sharp changes in interest rates. These extreme increases may cut off the debt markets and drive up operating costs for MLPs, but they are also indicative of strong index performance across all asset classes, which means more energy consumed.
MLPs offer the most diversification and lowest volatility
History has shown that MLPs have the potential to grow in rising rate environments, except for extreme fluctuations. Although MLPs are still a relatively new asset class, their performance during the previous ten rate increase periods showed an average gain of 4.7 percent, with positive returns in seven of the ten years.
Takeaway
Ultimately, if the Fed gradually increases interest rates, MLPs should continue to perform as well as expected. Particularly with significant increases in domestic oil and gas production, MLPs should continue to generate revenue growth and dividends for investors.