Win Both Ways with Kinder Morgan Energy Partners LP

Since the Federal Reserve Chairman Ben Bernanke unveiled plans to phase out the central bank’s program of quantitative easing, investors have been selling first and asking questions later. This news, coupled with rising interest rates on bonds, has weighed especially hard on dividend-paying equities that the market perceives as being overly sensitive to interest rates.

The yield on the benchmark 10-year Treasury note has surged by almost a full percentage point since bottoming on May 6, while closed-end bond funds that have rely on leverage to boost yields have also felt the sting. The popular PIMCO Strategic Global Government (NYSE: RCS), for example, has given up about 13 percent of its value since the start of May and, with a leverage ratio of 52 percent, likely faces further downside.

US government and corporate bonds had traded at inflated prices for an extended period, making it difficult for investors to lock in favorable yields without assuming excessive credit risk. The Federal Reserve’s easy-money policies contributed to the run-up in bond prices, though supply and demand also played a role. With companies having systematically reduced their near-term refinancing needs, the supply of new issues has been tight.

Does the Fed’s announced plan to curtail quantitative easing mark the end of the sellers’ market for bonds? It’s still too early to say. With Enterprise Products Partners LP’s (NYSE: EPD) bonds maturing Jan. 15, 2068, sporting a yield to maturity of 4.3 percent, it’s hard to argue that the corporate bond market isn’t obscenely overvalued.

By far, the fallout for dividend-paying equities has been the worst. Investors should regard this overdue correction as an opportunity to buy high-quality names at favorable valuations.

Why have stocks suffered more pain than many bonds? For one, equities offer superior liquidity, making them easier targets for the institutional money sloshing around. And many investors subscribe to the conventional wisdom that dividend-paying stocks serve as a proxy for bonds and will suffer when interest rates rise.

At the same time, the recent selloff in income-oriented equities likely reflects currents in the overall stock market, which has been shaken by fears that an uptick in interest rates will constrict economic growth. For the better part of two decades, dividend-paying stocks have tracked the fortunes of the major indexes and the economy–not interest rates. This trading pattern makes sense; earnings and dividends follow economic growth, which dictates stock prices.

A Buying Opportunity

Kinder Morgan Energy Partners LP (NYSE: KMP) has given up about 10 percent of its market value since the beginning of April 2013. At these levels, the stock sports a distribution yield of 6.4 percent–on the high side for a master limited partnership (MLP) that owns fee-backed midstream assets.

This pullback does not reflect developments at the company level; the blue-chip MLP has laid out a credible plan to generate distribution growth, posted solid first-quarter results, and announced several transactions and growth initiatives that will boost future cash flow. In short, units of Kinder Morgan Energy Partners have pulled back despite a stream of positive news.

Is there any rationale for Kinder Morgan Energy Partners’ unit price to track yields on 10-year Treasury notes? As pass-through entities, all MLPs must raise capital to fund growth projects and asset acquisitions; you could make the case that Kinder Morgan Energy Partners faces higher borrowing costs–a potential headwind when you consider that the firm faces $1.3 billion in bond maturities through the end of 2015.

But the prices on Kinder Morgan Energy Partners’ outstanding bonds have held steady since the selloff began. In fact, the interest rates on the MLP’s maturing debt are roughly in line with yield to maturity on its 30-year obligations, implying that the firm could at least refinance at the same rates. Opting to issue bonds with a maturity of 10 years would lower the firm’s cost of capital.

And $1.3 billion worth of maturing debt over the next two years is a drop in the bucket relative to the blue-chip MLP’s market capitalization of more than $29 billion.

What if the recent uptick in interest rates is a precursor to more inflation? Although we expect increases in consumer prices to remain muted, built-in escalators on the contracts backing Kinder Morgan Energy Partners’ pipelines should ensure that the MLP’s cash flow keeps up with inflation.

Kinder Morgan Energy Partners and other companies with the scope to grow their quarterly payouts are positioned to win both ways. In a low rate environment, investors will flock to the stock’s above-average yield; as rates rise, a growing distribution will separate the MLP from names with stagnant dividends. In short, Kinder Morgan Energy Partners will be a winner as long as the firm continues its track record of building and buying assets to grow its distribution and drive capital appreciation.

Kinder Morgan Energy Partners offers an above-average yield and the potential for distribution growth.

Investors looking for exposure to this story should also consider Kinder Morgan Management LLC (NYSE: KMR), which pays its distribution in the form of additional units and is suitable for IRAs and other tax-advantaged accounts. Kinder Morgan Energy Partners’ general partner, Kinder Morgan Inc (NYSE: KMI), sports a lower yield than the MLP but stands to grow its dividend at an accelerated rate. Note that Kinder Morgan Inc and Kinder Morgan Management issue the familiar Form 1099 at tax time, not a Schedule K-1. 

Roger S. Conrad is founder and chief editor of Conrad’s Utility Investor, Capitalist Times and Energy & Income Advisor.