With the 10-year Treasury yield recently touching highs not seen since 2011, it seems like an opportune time to revisit MLP performance in a rising interest rate environment. We discussed this topic in detail in a 2015 white paper, which provides historical context going back to the mid 1990’s. Today, we’ll focus on how MLPs have performed in rising rate environments since 2013 and key differences with the current environment that could have a bearing on MLP performance as rates increase.
For MLPs, rising interest rates can be a headwind in two ways: 1) fixed income investments become more attractive, increasing competition for investor dollars among yield vehicles, and 2) borrowing costs rise. There are several factors that have historically allowed MLPs to mitigate the negative effects of rising interest rates, particularly in comparison to other yield vehicles such as REITs and utilities. Today we’ll discuss those factors as well as other tailwinds for the MLP space that may help offset any negative impact from rising rates.
What can we learn from history?
MLPs have historically demonstrated a low correlation with Treasury yields. Using the Alerian MLP Index (AMZ), the weekly correlation for the past ten years between MLPs and the 10-year Treasury yield is 0.2, and the 15-year correlation is even lower. Given historically low interest rate levels over the past decade of less than 4.0%, the long-term correlation between the AMZ and 10-year Treasury yield may be less meaningful than if we had experienced more volatility at higher interest rate levels over the time period.
As an alternative, it’s informative to look at MLP price performance during more recent periods of rising rates. As shown below, MLPs significantly outperformed REITs and utilities during both the taper tantrum in 2013 and when rates nearly doubled in the second half of 2016.
How is today’s environment different?
It’s important to point out that each scenario of rising interest rates will have its own nuances. Relative to the periods shown above, the 10-year Treasury yield today of more than 3.0% is at a higher absolute level, creating more potential competition for yield. On the other hand, MLP yields are also at higher levels today than they were for the time periods in 2013 (5.8%) and 2016 (7.3%). MLPs’ higher yield today may help insulate them from the impact of rising rates. MLPs also boast a more attractive yield than Utilities and REITs as shown below.
Another contributing factor that helps MLPs offset the impact of rising rates is MLP distribution growth. The MLP space is generally leaving behind the old convention of 6-8% annual distribution growth in favor of more sustainable distribution growth and stronger balance sheets. Despite the fact that growth has generally moderated since 2013 as shown below, most AMZ constituents grew their distributions paid in 3Q18, and more than 80% of AMZ constituents grew or maintained their distributions relative to 3Q17 (read more). The significant increase for 2Q18 was largely driven by a 233.3% sequential increase in the distribution of Hi-Crush Partners (HCLP), which accounted for half of the 2.9% increase.
In the wake of the oil downturn that began in 2014 and saw crude bottom in February 2016, many MLPs have reduced their leverage, and balance sheet positions have generally improved. Stronger balance sheet positions should help mute the negative impact of rising interest rates on borrowing costs for MLPs.
From a fundamental standpoint, MLPs are also in a better position today with US oil and natural gas production at record highs. As volume-driven businesses, higher energy production supports high utilization of existing pipeline and infrastructure assets and creates growth opportunities. Beyond pipelines, MLPs are seeing growth in water services and export-related opportunities for oil and other hydrocarbons. MLP growth projects are built with customer commitments largely in place under long-term contracts and clear visibility to fee-based cash flows. Often, contracts will also include inflation adjustments, further protecting MLP cash flows.
How have MLPs performed as rates have risen this year?
If we look at price performance this year as rates have risen, the outcome is mixed. As shown below, MLPs outperformed REITs and Utilities as the 10-year Treasury yield gained 54 basis points (bps) at the start of the year. However, in the recent rate move, Utilities have provided better performance. Utilities were up slightly as the 10-year Treasury yield increased by 42 bps from August 24 to October 5, while MLPs and REITs traded lower. It’s worth noting that Utilities outperformed even before the flight-to-safety trade kicked in with the broader market pullback on October 10th and 11th when the Dow Jones Industrial Average fell by nearly 1,400 points over two days. Utilities have been perceived to be more defensive and may hold up better in an environment of rising rates if the market embraces a risk-off trade (read more).
Admittedly, past performance is only so helpful in evaluating how MLPs will perform as rates rise, and rates are reaching levels not seen in years. Balancing the higher level of interest rates with the advantages MLPs enjoy today, including a strong fundamental backdrop with record high US oil and natural gas production, improved balance sheets, higher yields than in past scenarios of rising rates, and distribution growth at a more sustainable pace, the tailwinds seem to outweigh the headwind of rising rates. These advantages may also support better relative performance for MLPs as rates rise compared to other yield-oriented investments.