Master limited partnerships (MLP) survived the Obama administration’s first major legislation, the recently passed health care bill. In fact, in light of the new tax on “unearned income” of up to 3.9 percent, their distributions–comprising mostly return of capital–look more attractive than ever.

Still on the table is the extension of a preferential rate for dividend taxes, with the top rate going from 15 to 20 percent. But however that goes, the MLP advantage will only increase.

The biggest sector risk from Washington is what happens to carried interest, the tax break that some financial constructs are using to declare themselves MLPs. The president’s budget would start taxing carried interest as ordinary income when it goes into effect in 2011, rather than as capital gains as they are now. Meanwhile, the House of Representatives has already passed its version of legislation, and the US Senate is taking it up.

Budgets are treated differently from other types of legislation in the upper house and can be passed simply by majority vote. And in any case, as the Obama administration and the Democratic Congressional leadership proved in passing health care legislation, they’ll do whatever it takes to get done what they believe needs to get done.

Over the past year, all but a handful of MLPs have moved to higher ground. That even includes several that cut distributions, such as KKR Financial Holdings LLC (NYSE: KFN). The carried-interest MLP has diced its distribution by 85 percent over the past year but is still up eightfold off its lows in 2010.

The “loser” ranks have basically been confined to real basket cases that have cut dividends, such as K-Sea Transportation Partners LP (NYE: KSP), which in fact no longer pays a distribution. It’s still rated a sell in How They Rate, just as it has been for many weeks.

Rio Vista Energy Partners LP (OTC: RVEP) has also nixed its payout, as its business model completely collapsed. It now trades only over the counter and still rates a sell. Finally, Terra Nitrogen Company LP (NYSE: TNH) has lost nearly half of its value after cutting its distribution by more than half. We continue to rate it a hold, however, on the basis of its strong asset base and the likelihood for a rebound in the global fertilizer market.

Discrimination Is Key

Unfortunately, with even the strongest MLPs starting to encounter some headwinds the next 12 months aren’t likely to be as kind to weaklings. And most vulnerable of all are MLPs like KKR and AllianceBernstein Holding LP (NYSE: AB) that rely on carried interest to pay their distributions. They’re literally a stroke of the pen away from generating huge losses.

We can’t emphasize enough how important it is to differentiate among MLPs–particularly now that so many have risen so far so quickly. The average investor–both individual and money manager–is taking far too much for granted here, a fact that’s plain from the huge gains many MLPs have rung up over the past year as well as their lower yields.

Given that many of the biggest gains are in MLPs with the weakest business profiles, it’s obvious investors aren’t doing a very good job differentiating, if they’re even trying to at all. And that applies to the professional money managers who run billions of dollars as well as the individuals looking for yield.

That’s the nature of all bull markets, be they for the full market or just a particular sector. After sticking only to the highest-percentage plays–or avoiding the sector altogether–investors suddenly pour into looking for almost anything. And when you’re talking about income stocks, the sole obsession for most is yield, with little thought given to the health of the business that’s essentially writing the checks.

Unfortunately, there’s always a day of reckoning, and when it comes things get extremely ugly very quickly for the bid-up stocks of weaker companies. The irony is we just saw this happen for MLPs, starting in late 2007 and accelerating through 2008 into early 2009. And much of the junk that was thrown together during Wall Street’s new-issue boom simply blew apart. Some yields that looked mighty attractive at one time became graveyards of capital. And with investors again failing to differentiate in early 2010, it looks like it’s going to happen again, at least to some people.

Agenda item No. 1 to ensure you’re not one of these folks is to sell all carried-interest MLPs. The good news is all you have to do is go to How They Rate, where all of them have been rated “SELL.”

Agenda item No. 2 is to size up your remaining MLPs for quality. And for that we have our proprietary MLP Profits Safety Rating System. The table below shows how the MLPs in our three portfolios stack up. We’ll be rating all the MLPs in How They Rate in the coming weeks.

The system is based on four components, each concerned with the safety of distributions, which is, over time, the driver of MLP unit prices.

Percentage Fee-Based Income. As we saw clearly during this recession, MLP income based on fee-for-service–or, better, for simply use of capacity–is rock-solid. Meanwhile, MLP income that depends on the level of commodity prices is as volatile as those volatile markets.

Under our Safety Rating System, we award one point to any MLP that draws cash flows primarily from a fee-based business. Note we don’t include tanker revenue locked in by long-term contracts or oil and gas producer revenue locked in by price hedging as equivalent to true fee income, which comes from activities such as operating pipelines and energy storage systems. Neither do we include activities such as gas gathering, where activity depends heavily on commodity prices, or any processing, where margins depend on commodity price spreads.

Profits in these areas are inherently variable. That’s something we often want to play, but it does up the risk to distributions over the long haul in particular.

Payout Ratio. This can be expressed in two ways, either distributions as a percentage of distributable cash flow (DCF) or by how many times DCF covers the distribution. Because MLPs’ structure allows them to minimize taxable earnings, the metric known as earnings per share (EPS) is a meaningless number. DCF is basically earnings adding back in those tax avoidance items, which are mainly accounting expenses that involve no outlay of cash, such as depreciation. Maintenance capital expenditures, which are needed to run the business and maintain equipment, are also taken out. The result is a true figure of how much cash an MLP has brought in that can be paid out in distributions. When measured as a percentage, lower numbers indicate greater coverage and therefore safety. When measured as a raw number by dividing DCF by dividends, higher numbers indicate greater coverage and therefore safety.

Most MLPs use the latter figure in their own calculations, but note that one is simply the inverse of the other. A coverage ratio of 1.25, for example, is equivalent to a payout ratio of 80 percent.

As with any other investment, a higher coverage ratio/lower payout ratio is always preferable. A business based mainly on fee income, however, can sustain lower coverage ratio than one where income depends mainly on commodity prices. As a result, we have what amounts to a two-tiered system. We’ll give a fee-based MLP a point for payout coverage of 1.1 to 1 or better, but we’ll only give a commodity leveraged MLP a point if coverage is 1.25 or better.

Debt. Like the rest of Corporate America that weathered the credit crunch, most MLPs are able to issue debt at their lowest rates in history. Enterprise Products Partners LP’s (NYSE: EPD) 10-year bonds now have a yield to maturity (YTM)–the measure of yield that includes bonds’ inevitable move to par value by redemption–of barely 5 percent. That’s versus a YTM of over 10 percent in early 2009 and 6.6 percent now for Enterprise’s common equity units. And even Regency Energy Partners LP’s (NSDQ: RGNC) paper is yielding less than 8 percent, despite just a B rating.

That cheap credit combined with high unit prices mean well-capitalized MLPs have their best access to capital perhaps ever, even at a time where industry assets are still going cheap. That’s fuel for robust distribution growth for some time to come–and the better the rating, the better the access.

Sooner or later, however, the cost of debt will rise again, and MLPs with high debt levels will be penalized for being overly aggressive. Consequently, we give each MLP a point under our safety ratings system if debt is 60 percent or less of total capital. That’s a level which would not be at all impressive at an ordinary corporation. But with MLPs’ tax advantages, it’s a very healthy level indeed.

Dividend Growth. Nothing showcases a healthy company or MLP like a consistently growing distribution. The only way an MLP can grow its payout consistently over time is if it can grow its cash flow. And it will only do that if it has a healthy and growing business. As a result, we generally award a point for any company that increases its payout over the past year.

Note that distribution increases by energy producing MLPs such as EV Energy Partners LP’s (NSDQ: EVEP) February increase–are particularly noteworthy given the extreme energy price volatility over the past year, especially the weakness in natural gas prices.

Our MLPP Safety Rating is divined simply by adding up how many criteria an MLP meets. Those meeting all four have the best-protected distributions of our universe, while those meeting none have the worst protected.

Using Ratings

Importantly, a low safety rating doesn’t necessarily mean an MLP should be sold, just as a high one doesn’t always indicate a buy. That decision also depends on such factors as price and yield, as well as how big a bet an investor wants to make on commodity prices.

That’s why we’ve essentially split our model portfolio into three parts. The Aggressive Holdings derive the lion’s share if not all of their income from businesses that are heavily influenced by commodity prices. Those influenced mainly by natural gas prices have lagged a bit. Those MLPs tied to natural gas liquids and oil, however, have been some of our biggest winners. A strategy of excluding all low-rated MLPs would have kept you out of most of them.

Those who don’t want to have any bets on commodity prices should almost always pick from our Conservative Holdings, with at most only a little exposure to Growth Holdings. Growth Holdings, meanwhile, are ideal for the middle of the road.

Our ideal strategy is to pick some from each group. But again, investing is a personal thing, and you have–or at least should have–your own goals and risk tolerance. Our job is to give you the best possible MLPs to meet your financial objectives–and that’s the only way to use the Safety Rating System.

Finally, rounding up, the news for Portfolio picks was fairly light this week, and likely will remain so until we get earnings that will begin coming in toward the end of April. The only thing we’re seeing is equity issues and the predictable selloffs that follow them.

The good news is these selloffs continue to prove temporary phenomena. Linn Energy LLC’s (NSDQ: LINE) moves were well documented last week in a series of Alerts. The good news is units proceeded to stabilize the rest of the week as more details came clear about debt reduction and the MLP’s plan to acquire natural gas properties from HighMount Exploration & Production for $330 million.

We remain bullish on Linn Energy, which rates a buy up to 28. And barring something extremely unexpected and unusual, we will be on any other of our picks that hit turbulence from doing what only comes natural to MLPs: issuing more equity to fund growth.

The only investors who are really hurt by these near-term happenings are those who try to play it too cute with stop-losses and trailing stops. We strongly advise you not to use these “risk avoidance” techniques with MLPs.

If a recommendation’s underlying business should come apart, we’re going to know about it a long time before the undiscerning crowd, which is wholly focused on yield. And as long as the underlying business is strong, dips due to technical factors like equity issues will be temporary and–when market conditions permit–a move to higher highs as units follow distribution growth higher.