Master Limited Partnerships Offer Juicy Yields

Carlos Davila | Photographer's Choice RF | Getty Images

Three IPOs this week are Master Limited Partnerships (MLPs) — part of a long string of MLPs that have gone public recently — at least seven since September, according to IPOFinancial.com.

Why the excitement? MLPs are backed by physical assets, usually oil and gas pipelines, that generate revenue under long-term contracts.

MLPs are hot for two reasons: 1) like REITs, MLPs are required to pass on 90 percent of income to investors, which means yields are attractive; and 2) when rates are low (as they are now), MLPs are able to keep growing because they use borrowed money to expand operations.

Today's IPO: USA Compression Partners (USAC), which priced 11 million shares at $18, below the price talk of $19 to $21 a share. They provide natural gas compression services. It's a juicy yield: nine percent.

This is partly a play on shale drilling and the concept that demand for natural gas will remain strong. The risks are that natural gas prices (currently low) will affect the amount of activity, and estimates of future earnings depend in part on compression service rates increasing.

This is the risk for most MLPs: you are betting to a large extent that demand for oil and natural gas will keep expanding. The fees MLPs charge to transport the oil and natural gas are based, for the most part, on volume, not commodity prices, so that smooths out a lot of the commodity price fluctuations. However, the prices of natural gas and oil will affect the amount of activity in the pipelines, so commodity prices ultimately do matter.

One issue for MLP investors: taxes. K-1 forms must be filed in every state each MLP operates in. This can be a real headache. But there are tax advantages: investors can partially defer paying taxes on distributions until they sell their shares. For distribution, most are treated as return of capital and are not taxed immediately, but subtracted from the owner's cost basis.

For those who do not want to deal with the headache of K-1 forms, there are several Exchange Traded Funds (ETFs) that buy baskets of MLPs that get a completely different tax treatment: investors receive a single 1099 form.

Another important point on taxes: MLPs, like REITs, are taxed at ordinary income, not the 20 percent preferential tax rate for qualified dividends.

Two other MLP IPOs this week: SunCoke Energy Partners (SXCP), which owns coke-making facilities to aid in steel production (8.25 percent yield) and CVR Refining (CVRR), which owns petroleum refining operations in Kansas and Oklahoma (18.8 percent yield!).