Kinder Morgan Energy Partners LP (KMP), Plains All American Pipeline, L.P. (PAA): Don’t Let Rising Rates Eat Your Lunch

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Like other income producing investments, MLPs exhibit strong sensitivity to interest rates. Over time, interest rate variations have exhibited influences on MLPs. Fortunately for MLP investors, the interest rate environment for most of the last decade and a half provided a tailwind for units. A progressively falling rate environment helped drive prices up on these securities in a yield-starved environment. Those times are changing and reassessing your MLP’s growth potential becomes even more important in that context.

Kinder Morgan Inc (NYSE:KMI)

There are a set of elite midstream MLPs that clearly outperformed peers over the years. These are partnerships that have succeeded in avoiding operational issues over time. Their steady execution gives them bond-like performance.

These Steady-Eddies include names like Kinder Morgan Energy Partners LP (NYSE:KMP), Plains All American Pipeline, L.P. (NYSE:PAA)Enterprise Products Partners L.P. (NYSE:EPDand Magellan Midstream Partners, L.P. (NYSE:MMP). Over the years, they’ve performed admirably, but they haven’t been immune to contractions. In fact, the group as a whole tracked the 10-yr Treasury notes at a 2% spread for much of their history; both up and down. Part of their remarkable success is attributable to the fact that they haven’t had to cope with an upward rate trajectory for any sustained period of time. With rates at historic lows, that will likely change for the worse.

It’s all about risk.
The reason is simple when viewed in the extreme. If the 10-yr were to push through 6%, would investors in Jimmy’s Used Car Park be willing to accept 6% when Uncle Sam’s offering 6%? No. His bonds require higher yields to attract investors. Jimmy’s junk would trade down in the secondary market until its yield was sufficiently high to warrant its higher risk. Existing bondholders would be left holding the bag.

It’s not really any different in intermediate cases. As Treasury rates rise, income producing securities of all types fall, repositioning yields in relation to Treasuries.

It’s not just corrections that can erode your MLP returns.
Once the market warmed to the new MLP products, the top MLPs moved in step with Treasuries. You can see below that the yield of each of the four correlates pretty well to Treasury yields over the years. Spreads sat around 2% for most of the period after the bubble. Only the serious corrections of 2002 and 2009 broke the pattern.

Naturally, all bets are off when panic arises. The flight to safety during the crash rallied Treasuries, dropping interest rates as economic uncertainty rose. Stock prices waned and the yield on Kinder Morgan Energy Partners LP (NYSE:KMP)’s units rose as they lost 25% of their value. Losses were worse in the 2008-2009 Credit Crisis as Kinder Morgan Energy Partners LP (NYSE:KMP) units shed 31%of their value. As with any equity, corrections can be costly.

While losses during corrections are understandable, losses during good times are harder to swallow. Twice between 2002 and 2008, Kinder Morgan Energy Partners LP (NYSE:KMP) units came under pressure even as the wider market rallied. Both periods corresponded to relatively brief periods of rising interest rates.

Notably, these rate-driven losses rivaled the 2002 and 2008 corrections in severity. Kinder Morgan Energy Partners LP (NYSE:KMP) shed 23 % as the 10-yr rose just a point in 2003. In 2005, a measly 0.5% increase in the 10-yr triggered a  21% decline. During both periods, the S&P 500 index actually rose.

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