With interest rates at historic lows, investors have been searching for yield and have found stable and growing cash flows with relatively lower cash-flow volatility in master limited partnerships (MLPs). However, comments from the Federal Reserve last spring indicating that the Federal Open Market Committee (FOMC) may taper its purchases of Treasury securities and agency mortgagebacked securities, resulted in an increase of 96 basis points (bps) in the 10-year U.S. Treasury bond yield from 1.63% to 2.59% in an eight-week time span (May 2 to June 25).

During this period, MLPs rose 1.1% on a total-return basis. However, performance was quite volatile, as MLPs experienced two major V-shaped price swings, falling 7.2% (May 22 to June 5) and 4.7% (June 18 to June 24), with subsequent corrections. While MLPs have recovered from the initial market shock of the Fed’s potential actions, the question on investors’ minds is how MLPs have responded historically in rising interest-rate environments.

The correlation between the Alerian MLP Infrastructure Index yield and 10-year Treasuries during the past 10 years has not been statistically significant, regardless of whether the data is analyzed daily, -0.04; weekly, -0.03; or monthly, -0.03. While MLPs may show no meaningful statistical correlation to interest rates over the long term, not all investors have the luxury of investment horizons measured in decades. In periods of market stress, correlations spike between all asset classes.

By comparison over the past decade, the target Federal Funds rate increased only during the 2004-2006 period, when rates rose by 25 bps every six weeks from June 2004 through June 2006. During the month that followed the initial announcement on April 21, 2004, Treasury yields rose 31 bps, MLPs fell 4.1%, and the MLP-Treasury correlation jumped to 0.92. By June, exactly one month after a near-term low, MLPs had recovered to previous levels, with correlations falling to 0.08. Indeed, on June 30, when the rate increase of 25 bps was finally announced, MLPs gained 0.8% that day.

During the actual two-year period from June 30, 2004, to June 29, 2006, when the target Fed Funds rate increased from 1% to 5.25%, MLP yields ranged between 5% to 7% and correlation between MLPs and Treasuries was higher than normal at 0.55. Contrary to investor fears, MLPs returned 38.7% on a total-return basis, anchored by continued increases in quarterly distributions.

As history has shown, MLPs typically respond unfavorably to unexpected announcements of future increases in interest rates. MLPs are income-producing equities and when interest rates move, everything with a yield is affected.

Over the long term, MLPs are not as tangibly affected as the broader market. From a business perspective, MLPs primarily use fixed-rate debt ranging from 10 to 30 years to fund growth projects. If interest rates were to increase, MLP balance sheets are likely unaffected in the near- and medium-term, as debt is locked in and interest payments are fixed. Also, MLPs exercise a higher degree of capital discipline, only pursuing the projects that exceed a certain internal rate of return, above cost of capital.

On the income side, many MLPs have a built-in inflation hedge as all interstate liquids pipelines are regulated by the Federal Energy Regulatory Commission and set to increase tariffs by the Producer Price Index + 2.65% each July 1. This contractual hedge is a trailing response, but it is more favorable than many other income-generating investments.

Like other yield equities, MLPs may sell off on the news of a potential rise in interest rates. But unlike other yield equities, the long-term distribution growth outlook for MLPs remains strong, particularly as the energy renaissance in domestic production has created billions of dollars of energy infrastructure investment opportunities. Stay the course.

Maria Halmo and Emily Wang, CPA, are directors for Alerian, an independent indexing company that provides objective market information. More than $13 billion is directly tied to Alerian’s indices, which include the leading benchmark of MLP infrastructure equities: the Alerian MLP Infrastructure Index (AMZI). For more information, please visit www.alerian.com.