In the May 19, 2010, issue of The Energy Strategist, The Big Picture: Energy Stocks and Europe’s Debt Crisis, I offered a detailed update on the master limited partnerships (MLPs) recommended in model Portfolios. I also advised investors to take advantage of the temporary dip to buy into this high-yield, tax-advantaged group. Since that article appeared, the MLPs in the TES Portfolios are up an average of 15 percent.  

The normalization of global credit markets has catalyzed this rally. Many investors were remained concerned that sovereign-debt crisis in Greece, Portugal, Spain and Italy would ultimately lead to another credit crunch.

My take was (and is) that fears of a second credit freeze are overblown. Since the May 19 issue hit the web, the TED Spread–a measure of strength in the interbank credit markets–has declined from May/June highs near 50 basis points to 34 basis points, the lowest reading since early May.

And Italian 5-year credit default swaps–a measure of the risk that Italy will default on its sovereign debt–have plummeted in recent weeks from June highs near 250 basis points (2.5 percent) to recent lows under 150 basis points. Many MLPs have raised capital at attractive rates via debt or new equity issuance, and units of some trade at new 52-week highs.

Just as I recommended that investors add risk in May and early June to take advantage of attractive valuations and sky-high yields, I am now advising a measure of caution. Many recommended MLPs now trade at or above their “Buy Under” prices listed in the “Advice” column of the Portfolio tables.

DO NOT be tempted to buy MLPs above these price guidelines; I review and evaluate my recommendations frequently and adjust those prices upward only as warranted.

It doesn’t pay to chase overextended MLPs; periodic pullbacks in individual names, and in the group as a whole, will provide favorable entry points for the patient investor.

I am making two adjustments today.

After Enterprise Product Partners LP’s (NYSE: EPD) solid earnings release, I’m boosting my buy under target to 38.

I am also raising the Tortoise Energy Infrastructure (NYSE: TYG), a closed-end MLP fund, from a Hold to a buy under 36. I cut the fund to a hold back in May because it was trading at a large premium to the value of its portfolio; that premium has now disappeared, and it’s a buy once again.

Popular New Funds

Another factor that’s pushed MLPs higher in recent weeks is the launch of several new funds that invest in the sector. These funds offer high yields and have attracted a good deal of investor attention; as more investors pile into the funds, the managers are forced to add to their positions in the group, supporting valuations.

A trio of new exchange-traded notes (ETN) issued by Swiss banking giant UBS (NYSE: UBS) appear to be garnering the most attention.  

UBS E-Tracs Alerian MLP Infrastructure (NYSE: MLPI) is designed to track the performance of energy-infrastructure MLPs. Top-weighted constituents include TES Portfolio recommendations Enterprise Products Partners and Kinder Morgan Energy Partners LP (NYSE: KMP). This particular ETN doesn’t include Linn Energy LLC (NasdaqGS: LINE) or any other names involved in upstream businesses.

UBS E-Tracs Alerian Natural Gas (NYSE: MLPG) is designed to track the performance of the largest MLPs involved with natural gas-related infrastructure assets. The list includes Copano Energy LLC (NasdaqGS: CPNO), Spectra Energy Partners LP (NYSE: SEP), and Duncan Energy LP Partners (NYSE: DEP).

Finally, UBS offers UBS E-Tracs 2x Leveraged Long Alerian MLP Infrastructure Index (NYSE: MLPL). This ETN tracks the same index as “MLPI” but employs leverage to double the performance of the index. The yearly fee for all three ETNs is a reasonable 0.85 percent.

The 2x Leveraged Long ETN is likely to garner the most attention from retail investors, as the leveraged exposure to MLPs means that it not only offers double the performance of the index but also twice the yield. Although the income generated by the ETNs will vary over time, UBS’ website currently indicates that the 2x Leveraged ETN will pay a yield of nearly 12.9 percent, compared to 6.6 percent for the Natural Gas ETN and 6.9 percent for the Infrastructure ETN.

An ETN is only as good as the index and MLPs that it tracks. As I noted above, the infrastructure fund and the 2x leveraged ETN include a significant weighting in MLPs that I recommend in the model Portfolios. That being said, whenever you buy an exchange-traded fund (ETF) or ETN you’re actually buying the good, the bad and the ugly within the index.

And before investors jump on that 12.9 percent yield, several factors are worth considering.

These three products aren’t exchange-traded funds but exchange-traded notes. ETNs are actually a form of debt issued by the sponsoring institution–in this case, UBS. In other words, when you buy the ETN you’re exposed to credit risk in UBS.

Also, because these products are ETNs, the quarterly distributions you receive are reported on a normal 1099 form rather than on the K-1 Partnership form used to report income from individual MLPs. In addition, the income you receive is ordinary income, NOT qualified dividends or partnership distributions.

Ordinary income is taxed at your full income-tax rate, which is likely to rise considerably in coming years as the Bush tax cuts expire and new taxes related to health care reform legislation go into effect. You won’t receive any of the income-tax deferral benefits associated with owning individual MLPs. One upside of this is that ETNs are an ideal candidate for IRAs and other tax-advantaged accounts.

The UBS ETNs are all designed to track monthly returns in the underlying index. Many ETFs and ETNs suffer from tracking error–that is, the funds don’t always reflect the performance of the index or commodity they’re designed to follow because of the frequency with which the portfolios are rebalanced.

Some of the worst culprits are exchange-traded products designed to track daily performance–these offerings are suitable primarily for shorter-term holders. One would expect a monthly product like the three UBS ETNs to suffer from less acute tracking error issues, though their limited history means that it’s tough to make that assessment until we have more trading data to analyze.

And tracking error doesn’t apply solely to capital gains from the ETN as compared to the underlying index. There’s also no guarantee that the ETN will pay double the yield on the associated index; that, too, will depend on exactly how and when the index is rebalanced.

Finally, note that leverage works on both the upside and downside. For example, the Alerian MLP Index pulled back roughly 15 percent from its closing high in April to its closing low in May. Investors should expect occasional corrections of 5 to 20 percent in the group, but those with longer investment horizons shouldn’t panic; for these investors, such pullbacks offer a buying opportunity.

Assuming the 2x leveraged UBS ETN performed according to plan, it would have likely corrected more than 30 percent from its April highs to its May lows. The question every investor needs to ask is whether they’re willing to accept that level of volatility from their investments. There’s no free lunch: The reward is twice the yield; the cost is twice the risk.

It’s often a good idea to wait a few weeks before investing in a new investment product. But investors should remember that the 2x Leveraged ETN is likely appropriate only for more aggressive investors willing to accept considerable volatility from their holdings. Don’t be tempted to bet the farm.

Join me for a Chat

Also, be sure to join me for an online chat on Wednesday, July 28 at 2:00 pm EST. I look forward to answering your questions about second-quarter earnings and all things energy.