A Rare Opportunity for Income and Growth

Extraordinary valuation opportunities are based not just on price, cash flow, yield and earnings stability, but those opportunities are based on alternative investment valuations too. With MLPs, we compare MLP yields to US Treasury yields. As of Friday, April 3rd’s close, the spread between MLP yields to 10-year US Treasury notes is at record levels—18.55%. Relative to other market crashes, this historic valuation is twice as large as that occurred during The Financial Crisis.

Historic Yield Spread:

“Those who do not remember the past are condemned to repeat it.” Philosopher George Santayana.

The chart below shows the MLP yield spread to Treasuries spiking to 1855 basis points over the 10-year US Treasury.

Below is a list of the 12 largest MLPs.

Two unpredictable and severe events drove the record market decline and MLP crash. First was the deadly Coronavirus, whose rapid spread has shut down cities, states and countries causing a simultaneous rapid global recession. Second, a dispute between Saudi Arabia and Russia led to a collapse in the OPEC+ alliance dropping oil prices to 18-year lows.While neither the stock market nor oil prices should impact MLPs, the modern computerized capital markets are so interlinked through indexes, ETFs, derivatives and leverage, that when the selling starts, a feedback loop of selling can prompt more selling. These factors drove the 35% 32-day decline in the S&P 500 and the 40% two-week decline in oil.

MLPs were subjected to forced selling because these stable high yield investments were and are a popular “carry trade” where an investment with high stable yield is leveraged and enhanced by borrowing at historically low-interest rates. This is fine until you have a pair of black swans that drive a three standard deviation market move which then creates forced selling. This happened to Kayne Anderson and countless other professional institutions including Goldman Sachs where leveraged MLP strategies suffered massive forced selling and disastrous declines—even though the underlying securities should only see a modest decline in cash flows.

Herein lies the opportunity. Knowing the value of a security and not just the price is what creates investment opportunity.

The overwhelming majority of the income generated by MLPs is fee-based revenues tied to volumes. Midstream energy volumes are related to the consumption of natural gas and oil. Both of these commodities have relatively noncyclical consumption volume patterns. While there will be some decline in travel due to this recession, the impact is unlikely to lead to distribution or dividend cuts as the distribution coverage ratio of the Alerian Index was 1.58 times in mid-March.

We have invested through the 1987 crash, 2000-2003, 2008-9, 2016 Oil and MLP crash and studied each decline and recovery. We believe a bottom occurred on March 23^rd and a significant rebound in MLPs will ensue.We have been investing in MLPs for over 18 years. The sharpest MLP declines, before this one, occurred in 2008 and 2016. Those MLP declines occurred concurrently with equity and oil market declines like the current crash. Those previous MLP bear markets rebounded with remarkable strength due to the incredible yield.

Lastly, the two Black Swans which triggered this disaster are now in retreat. The coronavirus has peaked and begun to decline in China and South Korea. Additionally, less constricting Italy, New York and New Jersey have also seen a peak in the number of coronavirus infections. Further, the United States is working to resolve this conflict and is in a position where it can cut production which both Saudi Arabia and Russia want.

The Market bottomed on March 23^rd and or is in the process of bottoming. The Fed Model shown below is flashing a near-record Risk Premium suggesting the stock market has not been this cheap since the Financial Crisis. Not only are stocks cheap but bonds are terribly expensive. This is when asset allocators sell bonds and buy stocks because 10-year US Treasuries yield 0.58% and the S&P 500 earnings yield is 6.17%.This is when you turn off the news and discuss with your perspicacious investment advisor what investments are trading well below fair value based on where that company, business or investment will be in the future. This is when you shift your cash, bonds or precious metal investments bought as a safe haven or for diversification purposes and reinvest that money in assets that are selling at exceptional values.

MLPs are durable franchises as they provide a nondiscretionary service. Like the Fed Model which compares the earnings yield of the S&P 500 to the 10-year Treasury note. The chart below again shows the differential between the yield on MLPs and the 10-year US Treasury note.

Based on our experience through previous declines, the stability of the underlying businesses and the current and inevitable recovery from the coronavirus and this oil price shock, MLP yields should return to their historic normal yield levels below 6%. The price implication for this sector is a triple. Not only is the price appreciation extraordinary, but the yield profile is also one of the most compelling we have seen during our career for a group of stable business franchises.

Kayne Anderson MLP / Midstream Investment Company (KYN) share price $3.67 as of 4/3/2020
NAV $4.42 16.9% discount. 39% $1.44/3.67

Kayne Anderson Midstream / Energy Fund KMF share price $3.08 as of 4/3/2020. NAV $3.81 19% discount. Yield 29.2% $0.90/3.08

Both of these funds had to reduce their leverage during this market rout. This led them to trade to large discounts to net asset value. Because of Kayne Anderson’s industry expertise, we like having them pick the MLPs to invest in, the diversity that portfolio provides, the inherent leverage which they are able to reassert as the market strengthens. In the coming days and weeks, we will see if the oil price war is resolved and how MLPs plan to address any weakness related to the energy sector and economy. As closed-end funds these assets can be held in retirement accounts which we think would be a tremendous opportunity in this low-interest-rate environment.

The holdings of both funds are listed below.

We have been in touch with an iconic West coast billionaire who read our email. This is what we wrote to him. We suggested investing “$10,000,000–we could lock in about 30% income or $3,000,000 a year in income. Then, in a year, you could have $20,000,000 to $30,000,000 which you could gift to your favorite charity.” We then thought he should invest $20,000,000 give away half in a year or so worth $20,000,000 to $30,000,000 and keep the other generating the about $3,000,000 a year for living expenses.

He has yet to call; however, market disruptions create extraordinary valuation opportunities, and this is a scenario we have capitalized on before and a space we have been focused on for nearly twenty years. This idea has compelling merit and it will work for smaller amounts too.