Content provided by Josh Jenkins, CLS Investment Research Analyst
Early last month Kinder Morgan shook the energy industry when it announced that it would be consolidating its four affiliated energy businesses into a single company. This transaction comes in light of recent underperformance of Kinder Morgan and its affiliated businesses, relative to the rest of the industry. The consolidation will allow the firm to bypass the large cash payments to its general partners, allowing it to pursue additional investment opportunities in the oil and gas space.
So, how does this deal impact ETF investors? Well if you have an income orientation, it could mean big changes for one of your likely holdings. Given the low level of bond yields, investors and fund managers have branched out to other areas of the market, buying up alternative income producing assets such as REITs, high yield bonds, senior secured bank loans, preferred stock, and Master Limited Partnerships (MLPs). Some of the largest impacts of the deal on the ETF’s adjustment will likely be index composition, impact on the yield, and taxes. This blog will focus on the impacts on AMLP*, as it is the primary MLP ETF holding at CLS.
Kinder Morgan and its affiliates is currently structured as a Master Limited Partnership; however, when the deal is completed, the entity will no longer fit this structure. On the day the deal settles (expected to be in the fourth quarter), Kinder Morgan (KMP) and El Paso Pipeline Partners (EPB) will be sold out of MLP ETFs, including AMLP, which currently holds about 12.5% of these entities. To understand the potential effects of this, one must note some features of the AMLP. This fund uses a modified cap-weighted methodology with 25 holdings at all times. There is a 9.5% cap placed on the top two positions and a 7% cap in the next four positions. The caps prevent the fund from being too heavily concentrated in the top holdings. KMP is the number one position, capped at 9.5%, while EPB is uncapped at 2.5%. When the funds are sold out of the index, the proceeds will be reallocated pro rata across the remaining funds and the two new funds.
According to Alerian, the firm that manages AMLP, the index reconstitution should have a muted impact on the dividend yield. Although the affiliated Kinder Morgan companies paid out slightly more income annually relative to other holdings, the growth of this income was lower than the rest. In total, Alerian anticipates approximately 10 to 15 basis points less income on an annual basis.
Tax implications of the index reconstitution should also be muted, because of the special tax treatment of MLP funds. MLP funds are required to accrue taxes on a daily basis as if the fund had to liquidate its holdings. As a result, the AMLP has already accrued a deferred tax liability that exceeds the taxes that will be realized when the two companies are sold out of the index. To pay any applicable taxes, there may be a need to raise cash by selling securities. Also, because the taxes accrued daily, there will not be an additional impact on the fund’s NAV when the two companies exit the index.
MLPs have been an invaluable tool in delivering a diversified source of income since the Federal Reserve’s easy money policy brought interest rates to all-time lows. Although the Kinder Morgan deal has a sizable impact on many funds that focus on this asset class, we do not believe it has made the MLPs any less attractive.
*The AMLP seeks investment results that correspond generally to the price and yield performance of its underlying index, the Alerian MLP Infrastructure Index.