A group of depressed closed-end funds offers a cheap way for investors to play the battered energy-pipeline sector, get ample yields, and avoid some of the tax hassles that come with master limited partnerships.
That’s no surprise, given that the entire energy sector is out of favor following the plunge in crude oil prices earlier this year. The growth of ESG (environmental, social, and governance) and sustainable investing has also dampened demand for traditional energy stocks.
Yet even with the growth in renewables, oil and gas will likely remain an important part of U.S. energy needs in the coming decades, and pipeline operators perform a critical role in energy transportation. And that makes the funds a bargain-basement opportunity.
The closed-end funds that focus on pipeline companies generally trade at discounts to their net asset values of 20% or more—the widest in the U.S. closed-end fund market, where the average discount is less than 10%.
“You’re buying the funds at a discount to an asset class that is already discounted,” notes Rob Thummel, a portfolio manager at Tortoise, which runs a group of closed-end funds focused on energy infrastructure.
These closed-end funds are called MLP funds even though pipeline companies are a mix of master limited partnerships and corporations; most used to be MLPs. These funds include
Kayne Anderson Energy Infrastructure Fund
(KYN), which until this past week was called Kayne Anderson MLP/Midstream, as well as
Tortoise Energy Infrastructure
ClearBridge MLP & Midstream
First Trust MLP & Energy Income
Yields range from 7% to 17%, reflecting double-digit yields on pipeline operators like Enterprise Products, Magellan, and
(ET) and often some financial leverage. Given the yields and huge discounts, the funds could easily return over 10% in the coming year.
“You usually get rewarded when you buy things that people don’t like,” says Bryn Torkelson, chief investment officer of Matisse Capital. “The MLP funds are the most discounted among all asset classes in closed-end funds.”
Matisse Capital runs the
Matisse Discounted Closed-End Fund Strategy
(MDCEX), an open-end mutual fund that buys discounted closed-end funds. It holds Kayne Anderson Energy Infrastructure and other pipeline closed-end funds.
The MLP closed-end funds have been hammered this year, with some down 75% or more. Pipeline stocks are down sharply, and the losses suffered by the funds have been magnified by leverage. Many funds were forced to sell stocks and cut leverage when pipeline shares tumbled in March. That deveraging occurred at the worst possible time.
Kayne Anderson Energy Infrastructure, the largest fund in the sector with net assets of about $690 million, now trades around $4, down 71% this year.
The funds more recently have come under pressure with the pipeline and energy sector, and discounts have widened. Kayne Anderson Energy Infrastructure Fund recently traded at a 25% discount to NAV, about double its average in the past year. Before 2019, it regularly traded at a premium.
The fund’s name change seems to reflect the sector’s disfavor, pointing to a mandate to allow greater investment in renewables, utilities, and natural gas.
More pain could be ahead.
Investors are fearful of the election, notes Greg Reid, president of Salient Partners, which runs the
Salient Midstream & MLP
closed-end fund (SMM), and there also could be tax-loss selling in the group before the end of the year.
“Investors may get a fat pitch in December, but it could be bumpy until then,” Reid says.
If Joe Biden wins the presidential election, there could be a greater emphasis on renewables over fossil fuels, especially if the Democrats win both the House and the Senate.
At the same time, there is profit pressure from lower energy prices and reduced volumes. The industry outlook has worsened as new pipeline projects have been canceled. A federal judge has ordered the shutdown of the Dakota Access Pipeline, which is seen as critical to the Bakken Shale basin, saying that the project didn’t do an adequate environmental review.
Investors’ concerns, however, seem already reflected in the market. Magellan Midstream, the subject of a favorable Barron’s profile in June, trades around $34 and yields 12%; Enterprise Products yields 11%, and Kinder Morgan yields 8%. Magellan recently said it expects to maintain its distribution during 2020, and Kinder Morgan’s payout looks safe.
“The biggest change in the industry has been a focus on free cash flow and cuts in capital expenditures,” says Thummel of Tortoise. “These companies can generate massive amounts of cash flow.”
Thummel likes industry leader Enterprise Products. At $16, its units are off 44% this year. It owns critical energy-infrastructure assets that are diversified by geography and commodity, he says, adding that it has relatively low financial leverage and a well-covered distribution.
The pipeline closed-end funds are structured as corporations or registered investment companies and offer investors annual 1099 tax statements rather than the dreaded K-1 forms that come with direct MLP ownership. The funds deal with the K-1 hassles.
These structures make them better suited to IRAs and other retirement accounts than the underlying MLPs.
Funds structured as corporations, like Kayne Anderson Energy Infrastructure Fund and Tortoise Energy Infrastructure, are subject to taxes on their income and realized gains, unlike the typical open-end or closed-end fund. This can act as a drag on returns.
As a practical matter, however, the corporate-level taxes for these funds generally aren’t onerous because MLP taxable income generally is much less than distributions, says New York tax expert Robert Willens.
“Even a C corporation investor in MLPs enjoys something of a tax advantage, in the sense that it’s only taxed on a fraction of the distributions it receives from the underlying MLPs,” Willens wrote in an email.
A closed-end fund that holds less than 25% of its assets in MLPs can elect to be treated as a registered investment company (RIC) and avoid taxes at the fund level.
Some funds with RIC status include
Kayne Anderson Midstream Energy
(KMF), Salient Midstream & MLP, and several Tortoise funds, including
Tortoise Essential Assets Income Term
Tortoise Essential Assets Income holds pipeline, renewable energy, and social infrastructure (investment related to housing and education) assets. It trades below $11, a 28% discount to its recent NAV, and is down from $20 at its initial public offering in early 2019. It yields 8.5%.
“With the energy transition to renewables, there will still be a need for energy infrastructure,” Thummel says. “Solar and wind power will grow dramatically.”
One drawback of the closed-end funds is high management fees, generally above 1%. Kayne Anderson Energy Infrastructure has a particularly high fee of 2.5%.
The funds incur a cost to leverage their portfolios, which sometimes is added to management fees in some calculations of expenses. The leverage expense is more than offset by investment income, however.
Some of the Tortoise funds, as well as other closed-end MLP funds, have bought back stock.
Yields vary considerably. Tortoise has taken a more conservative approach and is paying 6% on its Tortoise Energy Infrastructure fund’s NAV (or about 8% based on the current market price) because it wants to be in a position to retain income.
At a time of ultralow rates, the MLP closed-end funds offer an income bonanza and exposure to a depressed and still vital portion of the energy sector.
Write to Andrew Bary at [email protected]