MLPs for high yield

[dan_s]

From Citi Investment Research

MLPs Already Discounting Higher Bond Yields: Forecasting Midstream MLP Total Return of 8% in 2011

 2011 Expectations — From current levels we estimate the Citi MLP Index will generate a 2011 total return of 8% using a ten-year exit rate of 3.65%, distribution growth of 4%, and the median yield spread of 270 basis points. A sensitivity table to this analysis is provided on page 2. In short, investors should expect a slight headwind from increasing bond yields as Citi economists continue to expect the benchmark ten-year Treasury to move into a 3.5% to 4% range next year. The good news for MLP investors is that unit prices appear to have already priced in the lower end of this range excluding any benefit from distribution growth.
 Recent Underperformance — MLPs have underperformed the S&P 500 seven out of the last 10 weeks since the yield on the ten-year Treasury bottomed in mid-October at 2.4%. This week, the yield on the ten-year broke through 3.0% finishing the week at 3.32% and MLPs once again slightly underperformed the broader market. Importantly we do not find these short-term correlations unusual and fully expect MLP valuations to trend with interest rates on a near-term basis. Long-term, however, these correlations break down as changing fundamentals and distribution growth tend to have a greater impact on total returns for the sector.
 2010 Outperformance — To date, the Citi MLP index has outperformed the broader market by posting a total return of 32.6% vs. 12.7% for the S&P 500. This impressive performance was driven by a number of factors including strong fundamentals supported by continued shale gas drilling activities, asset acquisitions, tightening yield spreads, and a falling interest rate environment through October. Some of the factors that helped drive such strong performance for MLPs in 2010 are likely to continue into 2011 and some are not.
 Growth Could Surprise to the Upside — Despite falling interest rates and yield compression, the MLP sector has benefited dramatically over the last ten years from tremendous asset growth attributable to a combination of expansion projects and acquisitions. The MLP structure provides a cheaper source of capital for operators as valuations are based on pre-tax cash flows. As a result, MLPs have been aggressive consolidators of midstream assets and we believe this trend will continue in 2011. Low natural gas prices are currently driving many E&P companies to divest midstream assets to help offset depressed cash flows. Additionally, a focus on liquid rich gas plays is providing a number of expansion opportunities for some MLPs. In our opinion these factors could drive better than our currently forecasted growth and total return expectations in 2011.
 Our Recommendations — Across all MLP sub-sectors our top picks include EPD, EPB, NS, MMP, RGNC, SPH, and WPZ.